Global Trends by Martin Khor

Monday 26 May 2008

Oil price hike reaches “tipping point”

Last week the price of oil jumped and hit a new high of US$135 a barrel. At this level, some industries may go under, consumers are really feeling the pinch and economies may tip into recession or stagflation.


The international oil price hit a new high of US$135 a barrel at the end of last week, causing alarm bells to go off.  The oil price is now six times higher than in early 2002.

Though the rising oil price has caused grumbling through the recent years, somehow it seemed that many economies could absorb this trend quite well.

Not anymore.  There are signs that at US$130 a barrel, the oil price has reached the “tipping point” at which it is deeply affecting economies as a whole, as well as undermining not only profits but the survival of companies and sectors.

 "We may finally have crossed the line where the price of crude actually matters for most companies," according to a New York based equity specialist, Peter Boockvar, as quoted in Los Angeles Times.

"The economic outlook has been taken hostage by the relentless surge in oil prices," said Robert V. DiClemente, chief U.S. economist at Citigroup.

The oil price hike affects the economy in many ways.  First, many industries are hit, especially those that use a lot of oil.

Airlines are one of the most affected.  Profits have vanished in almost all U.S. airlines, which are reported to be on the verge of insolvency.  American Airlines is even charging passengers US$15 for a piece of luggage.

In Europe, British Airways is cutting back on flights, and warned its operating profits would be wiped out if the oil price is above US$120 a barrel.  Air France KLM said its profits are affacted and it will raise fares soon.

The auto industry is also hit, as sales of cars that use a lot of petrol are hit in the U.S.   With sales of sport utility vehicles plunging, Ford said there won’t be profits this year, and the situation at General Motors and Chrysler is rumoured to be even worse.

Second, the agriculture sector is also affected.  Rising oil prices have increased the cost of fertiliser, the operation of agricultural machinery and transport.  All this has contributed to the rapid rise in food prices, which in turn led to riots in many parts of the world.

Third, the higher cost of oil is winding its way into various parts of the production and distribution chains in many other sectors, causing inflation to rise across the economy in many countries.

This hits consumers in their pockets, reducing the volume of goods and services they can buy. The real pay of many workers goes down, causing a rise in poverty and social unrest.

Fourth, the slowdown in consumer spending is in turn slowing the sales of many products and services, which will affect the growth of the economy as a whole.

Fears of recession are growing in many countries. Indeed, memories have been revived of the situation of the 1970s, when the hike in oil prices led to “stagflation” – economic stagnation combined with inflation.

Fifth, in countries like Malaysia where there are controls on the prices of several oil products, the amount that the government spends on subsidies is ballooning.

The government faces a dilemma in these countries.  If they cut the subsidies, the prices of oil products go up and there will be public grumbling and even protests on the streets.  Moreover costs and prices in many sectors will shoot up, for example bus and taxi fares.

And if they maintain the controlled prices at the same level, the subsidies will keep shooting up, increasing the public sector’s budget deficit, or causing the government to cut spending in other areas.

Why has the oil price shot up so fast? First, demand is outpacing supply, especially with high economic growth in some big developing countries. 

Second, oil is a depleting resource, and we have reached (or are fast reaching) the situation known as “peak oil”, in which the global output has attained its highest level, and will go downhill after that, causing supply to lag more and more behind demand.

Moreover, as the best oil fields are exploited, more effort and costs are incurred to extract oil from fields that are of lower quality or more difficult to reach, and this contributes to higher prices.

Third, there is a frenzy of speculation in the oil market, not only because of a belief that prices will rise further but because speculative funds are searching for yield in oil and commodities after the collapse of confidence in the financial sector in particular and the volatility in the stock market generally.

The oil price trend is expected to continue.   The price of long-term oil contracts went up higher than the spot price last week ($145 a barrel for 2016 delivery versus spot price $135) “as confidence that supplies can meet demand in the next 5 to 10 years crumbled”, according to a Financial times report.

There are forecasts of the oil price hitting US$150 a barrel within weeks, and then the new threshold of US$200 will be in sight.

One positive point amidst the gloom is that this rising oil price is making renewable energy souces such as wind and solar more and more viable.  If these can take an increasing share of the energy market, that will be good for the fight against climate change.