IT WAS not meant to turn out this way. Whatever the moral implications and political consequences of the war in Iraq, markets were confident of at least one concrete economic benefit: cheaper oil.
The cost of crude rose ahead of last year’s military action, then tumbled once the conflict started. Between March 1 and April 1 last year, oil fell by $10 to trade at just $24 a barrel — fuelling optimism about what was at the time a nascent global recovery.
Yet this favourable development in the oil price did not last long. It was only months before a combination of geopolitical uncertainties and phenomenal demand from China sent the price climbing again. By the end of last year, Brent crude oil (the price of oil traded on the London market) was just shy of $30 a barrel — exactly where it was 12 months earlier.
By March prices had motored up to $32. By last Friday the price in London market was above $38, and the news from New York was even worse as oil breached $41 to set a record high.
Armed with these numbers, and a few stylised facts about past oil price trends, it’s easy to construct an argument that would scare even the most level-headed investor silly. Consider, for example, the following. The UK has only suffered from two full-blown recessions in the past 25 years: in the early 1980s and the early 1990s. And there have only been two occasions when London Brent traded at levels higher than last week: 1979-80, after the Iranian revolution, and 1990, after the Iraqi invasion of Kuwait. So whenever oil has risen as high as has done in the past seven days, full-blown recession has followed within 12 months. That, at least on the face of it, does not bode well for UK prospects.
But before you rush to sell your battered equity portfolio and put the proceeds under your mattress, note that there are a whole host of reasons why comparisons between the early 1980s, early 1990s and today are wide of the mark.
Not least among these are the widespread misunderstandings about the “record” high in the oil price set in New York late last week, which is not nearly as worrying as it might at first appear.
To start with, the New York Mercantile Exchange (Nymex) started trading crude oil futures only 21 years ago, in 1983. So although the oil price seen last week in New York was technically a “record”, Nymex’s trading history does not go back sufficiently far to cover the oil price shocks of 1973 and 1979. Series with longer histories, such as the Saudi light oil spot, show that prices are not yet at record highs, even in nominal terms. On the Saudi series, oil is currently trading at around $35 a barrel, compared with $40-plus in the early 1990s, and 1979-80.
These nominal price comparisons ignore the impact of inflation. But, as The Times reported last Friday, once you take that into account, the recent increase in oil begins to look much less worrying. If you adjust for changes in US inflation, oil needs to rise to about $80 a barrel to be as expensive today in real terms as it was in 1979. If you adjust for changes in UK inflation, then that figure is nearer $120 a barrel. The world economy as a whole is also much less energy intensive than it was 30 years ago, another mitigating factor.
The speed of the increase in the oil price is also a key ingredient in its overall impact on the economy. It is true that if you compare the lowest price seen in May 2003 — about $24 a barrel on the London market — to the $38.80 a barrel seen in London on Friday, then that looks like a hefty year-on-year rise.
However, oil was only briefly at $24 a barrel, and for much of last year was about $30. Compared with the $30 baseline, oil is up by about 30 per cent. In 1979 prices tripled, while in 1973 there was a fivefold increase in costs.
UK firms have had, at least until very recently, another cushion against the rising oil price — the weakening dollar. Oil, like most commodities, is quoted in dollars, and so the relative strength of sterling has helped to outweigh the impact of recent price rises. In dollar terms, London Brent crude may have risen 30 per cent, but in sterling terms the increase has been much shallower. Expressed in sterling, Brent averaged about £18.60 last year and is currently trading at about £22.20 — a rise of about 20 per cent.
There will be some impact of the rising oil price on the UK economy, albeit much less marked than in the 1970s. Motorists will have already noticed prices at the petrol pump beginning to rise, and companies — especially energy-intensive ones — will begin to see their costs edge higher.
In the 1970s central banks reacted to oil-induced price rises such as these by hiking interest rates. This was a key factor in the slowdown in growth that followed. Now there is a better understanding among policymakers about how to deal with supply shocks like a rise in the oil price.
For central banks, dealing with a demand-side shock — such as a sudden collapse in wages — is fairly straightforward. An unexpected drop in demand leads to a fall in output and to a fall in inflationary pressure, both of which are good reasons to cut interest rates.
But a supply shock is more complicated, as it pushes up prices (one reason to put interest rates up), but also reduces output (a reason to put interest rates down). Central banks need to balance these two considerations.
Economic thinking has evolved considerably since the 1970s, and central banks are much more likely to think twice before raising rates sharply in response to a supply shock than they were three decades ago.
When you also take into account that inflation is far lower today than it was in the late 1970s, or even the early 1990s, that is a further reason to believe that there will be no kneejerk reaction from central banks.
In the UK, inflation remains significantly below the Bank of England’s 2 per cent target. This gives Mervyn King, Bank Governor, plenty of breathing space. For now, the rising oil price is unlikely to change substantially the path for interest rates. Oil is not yet a reason to fear for the future of the global, or the UK, recovery.
