Like a precocious child seeing how long it can hold its breath, the world economy has remained defiantly indifferent to the relentless rise in the price of oil. Hardly a day goes by without West Texas Intermediate, the light crude that is the market benchmark, hitting new records. Oil for December delivery reached a trading peak of $93.20 (£45.46; €65.63) a barrel on the New York Mercantile Exchange earlier this week. It is just a matter of time before it smashes through the symbolic $100 barrier.
The Cassandras who thought sky-high oil prices would derail the world economy and stock markets have been confounded. Share prices are back on a strong rising trend, at least for the time being, while global growth is predicted to be an encouraging 4.8% next year, according to the International Monetary Fund (IMF) – not as high as previously expected but close to a record rate (the IMF’s slightly downward revision to its previous forecasts was due to problems in the American housing market and the global credit crunch rather than because of any oil price-driven slowdown).
Inflation remains under control, overall, despite the pressure from higher oil and petrol prices. The IMF cut its outlook for consumer price inflation in the advanced economies by 0.1 percentage points to 2.0%. This would have been unimaginable three decades ago when prices soared in the wake of the Iranian Revolution and Iran-Iraq war, let alone in the early 1970s when the oil-exporting cartel, Opec, imposed an embargo on the West in response to its pro-Israel policy.
A common notion, based on the experience of the early and late 1970s, is that oil price shocks trigger bitter recessions and double-digit inflation. But since 2002 the world has seen a threefold rise in oil prices and average growth in world gross domestic product (GDP) of almost 5% a year. Clearly this “common notion” needs to be revised.
The laws of economics have not changed, but the world economy has – dramatically so. It is now much better able to cope with a gradual, largely demand-driven increase in the price of oil. An IMF simulation of a repeat of a doubling in oil prices shows world GDP slowing at worst by 1.4 percentage points before returning to normal after two years. Inflation rises by 1.5 percentage points at worst, but the spike only lasts a barely noticeable five months.
The shocks of the 1970s were caused by an abrupt and overwhelming reduction in supply; now it is a gradual increase in demand – punctuated by regular hits to supply – that drives prices. Demand-driven shocks are much more gradual and allow the economy to adjust; the supply-side problems have remained manageable; and Opec has played almost no role in the recent spike.
The International Energy Agency (IEA) forecasts global demand will be 85.9m barrels per day (m/bpd) this year; next year, demand will jump to 88m/bpd. But supply is forecast only to rise from 85.2m/bpd to 85.6 m/bpd, leaving a shortfall of 700,000/bpd this year and 2.4m/bpd next year. Oil reserves are also at low levels. Last week America’s Energy Information Agency (EIA) said stocks had shrunk by 5.29m barrels in the week to 19 October to 3.17m, against forecasts of a 963,000 barrel increase.
The growth in demand is being driven by the booming emerging economies and the China effect, in particular, is key to understanding why oil is set to hit $100. The OECD estimates China contributed 24.3% of extra oil demand between 1995 and 2004, more even than America’s 20%. According to the IEA, Chinese demand will reach 7.6m/bpd in 2007 (up 5.7%) and 8m/bpd in 2008 (a further 5.6% rise). India’s oil demand is expected to rise 4.6% in 2007.
