Oil prices, emerging economies reshape global picture

03/01/2006

Economists differ when it comes to interpreting the significance of rising oil prices, which in real terms are approaching those which triggered the stagflation of the 1970s. Optimists suggest that market balance will be restored once supply side problems -- including bottlenecks in refining capacity -- are resolved. Others, factoring in the economic ascendancy of China and India, increased competition for resources and the threat of global warming, see a more complicated picture. In the past, the more pessimistic scenarios have been partly invalidated by technological advances and the operation of market forces. Will that be the case again? A collision of issues -- economic, political, strategic, and ecological -- suggests that policymakers should not be complacent, writes former Romanian Finance Minister Daniel Daianu.

By Daniel Daianu for Southeast European Times in Bucharest – 03/01/06

When the oil price went above $50 per barrel, the world started to worry. When it reached $70 per barrel in September -- subsequently slipping down to between $60 and $65 -- analysts began looking carefully at the next threshold.

The reason is clear: in real terms. $80 per barrel is equivalent to the price level which triggered stagflation in the Western economies several decades ago. At that time, Arab oil-producing countries used this strategic commodity as an economic and political weapon; in several rounds, the oil price escalated to over $40 per barrel. The price meant a drastic and considerable change of the terms of trade between the oil exporting and importing countries.

Today's higher oil prices thus raise a simple question: is the current situation similar to that of several decades ago? [File]

Wealthy, industrialised countries absorbed the oil price shock through economic slowdown (even recession) and heavy monetisation of their surging budget deficits. Over time, the rise in the price of industrial products compensated for the new price of oil. The combination of recession and high inflation -- close to 20 per cent just before the advent of Paul Volcker at the helm of the Federal Reserve -- confounded not a few macroeconomists; they had a hard time in accepting that massive under utilisation of resources can cohabit with a much quicker pace of inflation. Consequently, the conventional paradigm had to be extended to take into account the scenario in which a powerful supply-side shock overpowers the ability of the economy to undergo a smooth and fast reallocation of resources, as a means to absorb that shock. In this case, recession combined with higher inflation becomes inevitable.

Arguably, the Western economies experienced a shock which, decades later, was to be felt on a much grander scale by post-communist economies. Whereas the West had to deal with a brutal change in the terms of trade for a strategic commodity, post-communist economies had to deal with the wide-ranging institutional reforms and resource reallocation following the collapse of the Soviet trade bloc. Indeed, Soviet bloc countries were partially insulated at the time of the oil price shock, for they benefited from cheap oil from the former USSR. Poor oil-importing economies were the hardest hit, suffering a double blow: a much higher price of oil, plus gradually rising prices of industrial products.

Today's higher oil prices thus raise a simple question: is the current situation similar to that of several decades ago? On one hand, refining capacity bottlenecks indicate that there is a supply side problem, which was amplified by the consequences of natural disasters, such as the Katrina and Rita hurricanes. Likewise, oil exploration has not been expanded sufficiently in recent years. The policy implication is that market balance could be restored were these supply constraints eliminated. However, there is one major novelty in the picture: the economic ascendancy of Asia -- and particularly of China and India -- creates an additional, growing pressure on the oil and gas market.

Over time, the rise in the price of industrial products compensated for the new price of oil. [File]

The big question, then, is this: What is the potential impact of this new global economic picture on the price dynamic of basic commodities, on which the functioning of modern economies relies?

In a Malthusian, pessimistic scenario, further sharp price rises can be envisaged, with a struggle for the control of key resources. Let us recall the intellectual and policy-related debates after the publication of the Meadows report "The Limits to Growth" -- which was commissioned by the Club of Rome more than three decades ago. Likewise the modeling of global dynamics (the Forrester Model, developed by the MIT professor Jay Forrester) was stimulated in order to investigate what was likely to happen in the wake of severe change of circumstances on commodity markets. The Malthusian view was partially invalidated by technological advances and by the operation of market forces, which made the use of alternative energy sources profitable at the new prices. Could we bet again on technology and be complacent? Perhaps, but the answer has to take China and India into account.

The demand side shock is likely to continue, with Asian economies exerting pressure on the oil and gas market in the years to come. Arguably, this alone posts that the price of oil will not be returning to below $40 a barrel any time soon. Furthermore, although the price hike has been comparatively gradual, it is nevertheless forcing adjustments in consumption and production. Once again, the most severely hit are poor countries, especially those that import energy.

Several implications can be drawn. The competition for the control of oil and gas fields will intensify in the years to come, impacting geopolitical and security related concerns; a frantic search for new fields will be ushered in; oil and gas will be seen even more as highly strategic commodities and major economies will define external policies accordingly. It is highly probable that the needs of industries to be more competitive will collide with ecological concerns at a time when the effects of global warming are ever more visible and worrying.

Higher oil and gas prices slow down growth and lead to higher core inflation. Hence, major trade-offs for both firms and governments emerge, requiring policy clarity and thorough calculations of costs and benefits. A new thrust for energy conservation is to be expected under the new circumstances. Private and public budgets will be increasingly strained unless measures are enacted soon and implemented consistently over time.