Perils at the pump

Aug 12th 2005
From The Economist Global Agenda

Oil prices hit yet another record this week, on fears of political instability in the Middle East and refining problems in America. So far, the world economy has managed to chug along without much ill effect. But how long can consumers go on paying ever more at the pump without cutting back elsewhere? And why aren’t high prices bringing new supplies to market?

LIKE an athlete who has recently discovered steroids, the oil market just keeps setting new records. Over the past 18 months, the world has seen oil prices clear $40, then $50, then $60 a barrel, with each new record seeming to fall more effortlessly than the last. On Friday August 12th, American light crude topped $66 for the first time, thanks in part to fears of terror attacks in Saudi Arabia, an impasse over Iran’s nuclear programme and problems in American refineries. Costly oil was behind the 6.1% surge in America's trade deficit in June. Choppier waters are probably ahead: many analysts expect the price of oil to continue crawling towards $70, and beyond.

Dazed consumers are not the only ones wondering where this relentless upwards march will stop. Economists, looking at a world economy in which cracks are already starting to appear, are getting distinctly fidgety about the prospect that higher oil prices may bring on inflation, or recession, or both.

So far, however, the effect of higher prices has been surprisingly muted. Gas-guzzling America has seen GDP grow at a brisk clip, far outstripping many of its daintier peers in the rich world. Though high oil prices are contributing to America’s surging (and unsustainable) current-account deficit, they do not seem to be worrying consumers, who have kept on spending.

In part, this is because the oil-price records are an illusion, brought about by inflation. While nominal prices are at record levels, in real (inflation-adjusted) terms they are still well below those seen in the wake of the 1979 Iran hostage crisis, when the cost of a barrel of oil hovered around $90 in today’s dollars (see chart). Consumers are better-off now—in 1980, the median personal income in America was $16,800 (in 2003 prices), versus $22,700 in 2003—and economies are more fuel-efficient. Both of these things should cushion the shock of higher prices.

Some economists also think that there is a big difference between the supply shocks of the 1970s and today’s demand-driven price increases. For one thing, increases caused by growing demand are not quite so sudden. For another, they are far more responsive to market conditions; as the oil price rises beyond the level economic activity can support, growth, and thus demand for oil, should slacken. In contrast, when prices fell from their post-hostage-crisis highs of the early 1980s, the Organisation of the Petroleum Exporting Countries (OPEC) tried to keep them higher than the market could comfortably bear.

Learning from the past

The oil shocks of the 1970s brought with them a bitter lesson for OPEC producers: high prices led consumers and governments to make their economies dramatically more fuel-efficient, and non-OPEC countries to expand their oil-pumping capacity, meaning OPEC had to scale back production ever more to keep prices high. These days, the oil-producers’ cartel is wary of letting prices rise high enough to make a sizeable dent in world economic growth, or of provoking oil-consuming countries into boosting fuel efficiency further.

So why hasn’t OPEC done more to lower prices, which have risen by 50% since the start of the year? The answer is that, in the short term at least, the cartel seems to have lost control over the market. With the exception of Saudi Arabia, its producers are pumping as much as they can—and Saudi excess capacity is in heavy crude that is harder to refine into the cleaner fuels demanded by rich countries. OPEC made a great show of raising its members’ combined quotas to 28m barrels per day (bpd) in June. But thanks to rampant cheating, they were already pumping at least that much, and possibly as much as 30m bpd, making OPEC’s promises little more than a carefully staged bit of public relations.

Over the longer term, of course, producers can invest in new capacity. But OPEC is haunted by another bitter memory: $10-a-barrel oil after the Asian financial crisis cut cruelly into world demand in the late 1990s. This makes its members more reluctant than they otherwise would be to ramp up supply in response to surging demand.

A lack of pumping capacity is not the only supply-side problem. Once crude is taken from the ground, it must be refined into petrol, heating fuel and so on. But thanks in part to opposition by consumer groups to installations in their back yard, especially in America, not enough new refineries have been built to meet growing demand. Refiners have so far coped by improving refining technology, but tight capacity leaves the system vulnerable to price spikes when bottlenecks appear.

Nonetheless, relief may be on the horizon, though perhaps not as near as consumers would like. America’s Department of Energy predicts that growth in Chinese oil demand—one of the main factors driving current price levels—will moderate, increasing by 600,000 bpd in 2005 and 2006, down from 1m bpd in 2004. And there remains the possibility of a delayed reaction to current price levels, as consumers, particularly profligate Americans, turn to less thirsty cars and appliances.

Most analysts predict that oil prices will remain high into 2006. But a recent report from Cambridge Energy Research Associates predicted that as much as 16m new bpd could come onstream by 2010, which would probably mean a precipitous drop in prices. And even without new supply, as prices creep towards $70 a barrel, they will get close to setting real records, as well as nominal ones. At those levels, consumers, and their governments, can be expected to react. The market may eventually be able to accomplish what environmentalists seemingly cannot, by forcing energy-gluttons out of their sport-utility vehicles and on their way to a more fuel-efficient future.

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