Skip to main contentSkip to navigationSkip to navigation
Traders
Crude oil traders at the New York Mercantile Exchange as oil prices rose in response to upheavals in Libya. Photograph: Mary Altaffer/AP
Crude oil traders at the New York Mercantile Exchange as oil prices rose in response to upheavals in Libya. Photograph: Mary Altaffer/AP

Still-fragile world economy braced for effects of another oil shock

This article is more than 13 years old
Indebted households have already tightened belts. Higher petrol costs are likely to depress demand and prices – just what the recovery doesn't need

The outbreak of revolutionary fervour on the streets of Cairo and Tripoli has made compelling viewing, but the latest jump in oil prices last week was a sharp reminder that the consequences of chaos in the Middle East will be felt across the world.

Brent crude has come down to $112 a barrel, after hovering close to $120, but that's still an increase of more than 10% in seven days, an increase the global economy can ill afford as it struggles to find its feet two years after the wrenching crisis of the credit crunch.

The initial impact of a higher oil price is, not surprisingly, a rise in the headline rate of inflation, as costlier oil feeds through to petrol prices, and eventually the cost of all sorts of other goods that use oil, from plastics to fertiliser.

But how an economy copes in the longer term with such a one-off jump in energy prices depends on its underlying health. If demand is strong enough, workers can respond to the rising cost of living by bidding up their wages, and companies, in turn, can pass on their rising costs in higher prices, instead of taking a painful hit to their margins. This is the kind of toxic "wage-price spiral" Britain became locked into after the early 1970s oil shock.

For fast-growing emerging economies, many of which were already concerned about reining in inflation – Russia and China have both been raising interest rates, for example – the inflationary effect will be the biggest danger in the coming months, and central banks will want to take firm action.

Melissa Kidd, economist at Lombard Street Research, says the strong demand from China and other healthy economies will mean oil prices will not plummet back down to earth as they did two years ago, after hitting $145 a barrel. "Rather than a repeat of July 2008, where everything just collapsed, it will be this slow-burning monetary tightening," she says, predicting that it will be 2012 before these anti-inflation measures really start to bite, choking off demand in the emerging world and bringing the oil price back down to earth.

In the west, meanwhile, where consumers and governments are still working off the legacy of the noughties boom, the story is different. Where demand is already fragile, and workers are unable to push up their wages to compensate for the rise in energy prices, the oil shock could simply act like a tax – yet another rising cost that hard-pressed households have to bear. With a fixed budget, they are forced to respond by tightening their belts. So in the long term, the impact of rising oil prices is deflationary: it depresses demand.

Karen Ward, senior international economist at HSBC, puts it like this: "Without an increase in pay, using more of the monthly pay cheque to fill up the petrol tank will mean households have little choice but to cut back on other spending – eat out a little less, and buy fewer new clothes. In this scenario, a rise in oil prices simply serves to dampen spending on domestic goods and services, and depress their prices."

Governments can help to offset this effect temporarily, using subsidies or tax cuts, but that looks impossible given the dire state of public finances in most developed countries. (Chancellor George Osborne may, however, attempt to dull the pain of recent petrol tax rises in next month's budget with a so-called "fuel price stabiliser".)

Consumers could borrow to tide themselves over the short-term squeeze, but again, that doesn't look very plausible for the heavily indebted households of the US and much of Europe. Higher oil prices have occurred "at the worst possible time", according to Ward, with central banks already concerned about their inflation-fighting credibility in the face of rising global commodity prices.

In the UK, the latest rise comes as Bank of England policymakers were already juggling the conflicting influences of strong international commodity prices and sickly demand at home. News that GDP had contracted by an even larger than expected 0.6% at the end of 2010 will only sharpen their dilemma. Kidd at Lombard Street says they should grit their teeth and keep rates on hold, though she admits this will take "nerves of steel" in the face of the clamour for higher rates in some corners of the City – and among members of the monetary policy committee, including the hawkish Andrew Sentance.

Gerard Lyons, chief economist at Standard Chartered, warns that if the Bank makes the wrong decision, the UK could be at real risk of relapsing into recession. "A double dip could be caused by one of three things – a policy mistake, an external shock, or a loss of confidence," he says. "With rising oil prices, it's possible that here in the UK we could get all three. Higher oil prices are a shock in themselves; if they then led to a loss of confidence, and we foolishly raised interest rates, that would be a killer."

At the same time, some analysts are pointing out that it is important not to rule out more extreme scenarios in the Middle East in the months ahead. Saudi Arabia's King Abdullah announced a $35bn package of handouts to calm his restive nation last week, including the introduction of unemployment benefit for the first time.

Most experts believe Saudi Arabia is stable, but many would have said that about Egypt, Tunisia and Libya even a few months ago. Saudi supplies can easily offset the shortage of oil production from Libya; but if the chaos spreads to Riyadh, all bets are off.

Kidd adds that even without a revolution on the streets of Saudi Arabia, some other scenario could hit the world economy by shattering confidence: the oil shock could be compounded by another, unexpected and unrelated, event bursting into the markets' consciousness – a renewed fiscal crisis in Spain, for example. That could send markets spiralling downwards, by shattering the sanguine world-view of many investors and causing confidence to collapse.

For now, she says, the most probably impact of the oil shock is that it will act as a "slow puncture", gradually letting the air out of the world economy over the next two years or so – but it wouldn't take too much more bad news to turn it into a blowout.

Oil firms profit

It's no surprise that high oil prices are good news for oil companies, directly boosting their profits. In the past fortnight the FTSE 100 index of shares has fallen by 1%, but the likes of BP and Shell have increased their price by 2.5% and 4% respectively.

High prices also make more expensive ways of producing oil economic. Oil giants such as Shell typically judge the viability of long-term projects assuming an oil price of $50-$90 a barrel. Clearly prices are well above this level, but based on the industry's past record, it will take at least a year of much higher oil prices before companies ratchet up their assumptions.

When oil prices slumped to below $50 a barrel following the financial crisis in 2008, oil sands projects – the more expensive of which are only economic at $60 a barrel – were the first to be scaled down. Oil prices are so much higher today that almost any form of oil and gas production looks attractive. But first the reserves have to be found, frequently in inaccessible regions such as the Arctic, and the higher prices – and the gusher of profits that results – will encourage companies to look harder.

Andrew Horstead, risk analyst at consultancy Utiliyx, points out that an extreme increase would be bad for the industry in the long term, as consumption would drop and consumers might permanently switch to alternative sources of energy. 'But no one knows what level that tipping point is,' he says.

Tim Webb

Motorists squeezed

Every $2 rise in the oil price equates to an extra 1p on pump prices, according to the AA, with the recent rise threatening to add £2.50 to the cost of filling up a tank. A recent survey shows that three-quarters of the motoring organisation's least well-off members are either cutting back on household spending in order to fund their car costs, or reducing four-wheeled trips to the shops, work and school.

An AA spokesman said: 'The social consequences are that the freedom of the road is being steadily denied to members of society who are on lower incomes. They need that access for equality in society, to get to their jobs and take their children to school in the same way that everyone else does.'

Stephen Glaistercorrect, director of the RAC Foundationcorrect, warned that the average household already spends more on transport than on heating, mortgage costs or food, and will be hit hard if the oil spike filters through to pump prices.

According to the Office for National Statistics, transport accounts for more than £1 out of every £10 spent by a UK household. On top of that, it is the poorest households that own the least fuel-efficient cars.

Glaister says: 'At least half of those living in the poorest 10% of households now have access to a car. It means they can live normal daily lives. But for how much longer? While the relentless rise in fuel prices is punishing us all, the poor are being particularly hard hit.'

Dan Milmo

Comments (…)

Sign in or create your Guardian account to join the discussion

Most viewed

Most viewed