Each of the last five major downturns in global economic activity has been immediately preceded by a major spike in oil prices. Sometimes (e.g. in the 1970s and in 1990), the surge in oil prices has been due to supply restrictions, triggered by Opec or by war in the Middle East. Other times (e.g. in 2008), it has been due to rapid growth in the demand for oil.
But in both cases the contractionary effects of higher energy prices have eventually proven too much for the world economy to shrug off. With the global average price of oil having moved above $100 per barrel in recent days – about 33 per cent higher than the price last summer – it is natural to fear that this latest oil shock may be enough to kill the global economic recovery. But oil prices would have to rise much further, and persist for much longer, for these fears to be justified.
With global oil supply already impacted by Libyan shut-downs, the threat of an oil shock has moved well beyond the realms of the theoretical. According to recent reports, about half of Libya’s 1.6m barrels per day of oil output have been knocked out, and this has been enough to trigger a rise of about $14 per barrel in the spot price of oil in the past week.
Total Libyan oil production is less than 2 per cent of the world total, and it is of course most unlikely to be lost on a permanent basis. According to the head of the oil division at the IEA, the current level of IEA reserves is 1.6bn barrels, which could be used to supply an extra 4m barrels a day for a whole year if needed. On top of this, the potential extra production capacity among Opec producers is variously estimated at between 4 and 6m barrels a day.
True, some analysts claim that it would be extremely difficult to bring this potential output on stream rapidly, and others argue that it would not directly substitute for the types of crude produced by Libya. But it is surely very hard to deny that oil stocks are generally in much better shape than they were when prices rose to over $145 per barrel in 2008. And Opec spare capacity is about twice what it was then, even on a pessimistic read. Since the Saudis have already started to step up production in recent months, and since they will need more oil revenue to pay for the extra government spending which was announced yesterday, there seems to be sufficient available supply to offset the output disruptions we have seen so far.
However, political contagion in the Middle East is taking on a life of its own, and the original assumption that there would be a firewall between the populous, oil-poor economies like Egypt, and the much richer oil producers in the Gulf, seems shakier by the day. How far would oil prices have to rise before the upswing in the global economy would be seriously threatened?
At today’s oil price, crude oil consumption currently represents about 5.0 per cent of world GDP. (This is higher than often estimated because of the recent rise in oil prices.) Consequently, a rise of $20 per barrel in average crude prices would increase world expenditure on oil by 1 per cent. That is probably a reasonable estimate of the initial impact of such a price rise on global spending outside the energy sector. Although energy sector revenue would automatically rise by exactly the same amount, oil companies and producers would be unlikely to spend all of that immediately, so global demand would be likely to fall quite sharply as a result of the transfer, perhaps by the full 1 per cent.
What would happen next depends on several factors. Multiplier effects from the initial drop in spending would worsen the impact, as would any tightening in monetary policy needed to control the inflationary effects of higher oil prices. Therefore the effect could be larger than 1 per cent of GDP. And the damage would vary quite widely between economies. For example, the higher energy intensity of emerging economies means that a $20 per barrel price increase would cost them about 1.1 per cent of GDP, compared with 0.8 per cent in the developed world. Among developed economies, the US would lose most (0.95 per cent of GDP) while European countries like Germany would benefit from their lower energy intensity and would therefore lose least (0.52 per cent of GDP).
It is important, though, to remember that none of these effects would do much damage unless they were expected to last for quite a long time. Otherwise, consumers would just dip into their savings to finance what they expected to be temporary increases in energy expenses. Therefore the severity of any oil price shock should be judged not only by the size of the short term spike in oil prices, but also by its duration.
In the graph below, I measure the possible size of the “oil shock” by taking the annual change in the 12 month moving average of the global oil price, based on three different assumptions of the course of oil prices from now to the end of 2011. These are:
(i) the status quo at $100 per barrel;
(ii) a fairly pessimistic case in which oil prices rise to $120 per barrel and stay there all year; and
(iii) an optimistic case in which prices fall back to $80 per barrel, where they were expected to be before recent political disruptions.
It is clear that on the optimistic case, the 2011 oil shock would be a very minor one, and even in the middle case, the oil shock would be only of similar magnitude to what was observed in 2005-2006, when the global economy continued steaming ahead with a GDP growth rate of about 5 per cent. However, on the pessimistic case, the $40 a barrel annual rise in oil prices, persisting for about a year, could cut global GDP growth by about 2 per cent, and that would be very hard for the world economy to cope with.
How likely is it that oil prices could rise to $120 per barrel and then stay there for the better part of a full year? In my opinion, this is not particularly likely – unless Saudi Arabia explodes. Then, as they say, all bets are off.
*Gavyn Davies is a macroeconomist who is now chairman of Fulcrum Asset Management and co-founder of Prisma Capital Partners. He was the head of the global economics department at Goldman Sachs from 1987-2001, and was chairman of the BBC from 2001-2004.
He has also served as an economic policy adviser in No 10 Downing Street, an external adviser to the British Treasury, and as a visiting professor at the London School of Economics.