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What does the price of oil really tell us?

There may be a temptation to believe that because the price of oil has dropped dramatically since June we will immediately benefit from lower fuel costs, there are negative aspects such as lower inflation and economic growth.

News Team

Oil is a ubiquitous commodity.

Whilst we know that it is important, the number of daily products we use that include oil is truly amazing.

Equally important is the dependence we have on oil to travel or for the goods we buy. You only have to recall Fuel tanker drivers' dispute of 2002 to realise how utterly dependent we are on the supply of oil and its derivatives.

Oil, most particularly the price it is traded at, is once again in the news.

On this occasion it is because of the fact that in recent months we have seen a dramatic reduction the reasons dues to what are seen as poor economic prospects in developing countries such as China and in the Eurozone coupled with increased production by the likes of Libya, Iraq and Russia which is suffering its own woes due to the decline in the rouble and international sanctions because of its believed involvement in the war in Ukraine.

Though there may be a temptation to believe that because the price of oil has dropped dramatically since June we will immediately benefit from lower fuel costs, there are negative aspects such as lower inflation and economic growth.

A significantly reduced oil price hits revenues collected which means that whoever is chancellor has less income which affects us all. This is decidedly worrying given our own parlous economic state.

Indeed, should the lower price of oil persist beyond the short-term it will undermine the economic imperative for independence that is argued by Scottish nationalists.

Economic historians know only too well that rapidly declining asset values have the tendency to create social turbulence that frequently leads to revolution.

Some commentators are speculating that this may occur in countries – Russia is especially cited – that are heavily reliant on oil revenue to maintain ‘prosperity’.

One peculiar effect that I have seen reported is that so called ‘Petro-Powers’, such as Qatar, may have less money to invest in purchasing property in London which, I guess, would be no bad thing.

More pointedly, a fall in the price of oil that sustains will most certainly undermine the economic viability of sustainability initiatives such as alternative ‘green’ energy so vital to reducing the effects of global warming.

Additionally, oil reserves that are inaccessible are more expensive to extract, such as those in The North Sea (see Scottish Independence debate!), means that the falling price currently being experienced may cause them to become uneconomic and possibly mothballed.

This reduces the overall stock available in the short-term which, eventually, will probably cause prices to rise again.

Such is the way of markets.

However, oil enjoys socio-political and economic dynamics putting it into a class of its own as an indicator of what the world is experiencing and it’s salutary to examine how and why its price has fluctuated over the past 41 years.

In the early 1980s for a short time I worked for a development company which regularly used tarmacadam subcontractors. When paying these companies it was necessary to use the ‘NEDO price factor’.

The need for this cost adjustment had come about a due to the turmoil 1973-74 when an embargo by OPEC [Organisation of Petroleum Exporting Countries] caused the price to rise dramatically.

Using the inflation-adjusted for CPI West Texas Intermediate (WTI) measure, the US benchmark price that is closely associated to the Brent Crude measure, demonstrates that a barrel of oil increased from just over $21 in January 1973 to £51.74 in January 1974.

Tarmacadam companies who had quoted for work prior to the oil price rise lost out because the material used is directly linked to the price of the natural resource from which it is derived. As a result unless there was a guarantee that they would be compensated they were reluctant to enter ‘fixed price’ contacts.

The ‘first’ oil crisis of 1973 was a major shock to major economies and heralded the end of the supply of a consistently cheap commodity that we’d all become accustomed to.

Tarmacadam companies were no different to everyone else in realising that oil was a commodity so vital to everyday existence and that its price could be volatile.

Moreover, we became fully aware that the world’s total stock of oil reserves is fixed (though the exact figure is still disputed) whereas demand is ever-increasing.

Indeed, since 1973 there is an insatiable demand by all major industrial economies such as America, European countries and, initially in the Far East, Japan though now joined by the other ‘Asian tigers’.

Effectively, we had to acknowledge that the more oil we collectively used to ‘power’ our economies the faster we used up what some refer to as ‘black gold’.

So, any hope that the price might return to pre-crisis levels were short-lived and the norm for the remainder of the decade was between $50-55 until the next shock in 1979 as a result of the Iranian revolution when it peaked in June 1980 at $114.94.

Remember, these are inflation adjusted prices so in the course of eight years the price of oil had risen over fivefold in real terms.

Having peaked at almost $115 (WTI) in June 1980, oil prices declined pretty constantly thereafter and reached $67.28 in November 1985 after which they dropped rapidly to reach $27.61 in March 1986. Thereafter until late 2003, oil traded between the upper $20s and $40 though, for a short period in 1990 spiked at $64.05 quickly falling back.

December 1998 is significant in that oil reached the lowest inflation-adjusted price it has been since 1970; $16.38 a barrel (WTI).

The period after December 1998 was, with the usual fluctuations, a period in which the price rose consistently.

The period January 2007, when the price of oil was $64.17, to June 2008, when it hit an all-time high of $145.69, is notable in that all major economies were booming.

A major influence in the rise of the price of oil was demand from China.

The magnitude of China’s population and its desire to desire to invest in manufacturing capacity and urban growth whilst offering potential opportunity as a market created concern as to whether world supply could cope in the short-term and, more worryingly, whether the total reserves would be exhausted sooner than anticipated.

The summer of 2008 saw the beginnings of the catastrophe that is now known as the ‘credit crunch’ the consequence of which was a phenomenal drop in demand for goods which reduced output and led to a staggering drop in the price of oil from the high of $145.69 in June 2008 to £43.93 in February 2009.

For all-too-many the effects of the global financial crisis has been devastating in terms of job losses, severely reduced income and vanishing future prospects (see my article last week).

Recovery, demonstrated by a steadily increasing oil price trading at over $90 for the last four years reaching a high of $116.46 in April 2011, has been agonisingly slow and is still extremely fragile.

Accordingly, therefore, what has happened to the price of oil since June, when the price was $105.93, gives serious cause for concern.

The statistical data I am using shows the current inflation-adjusted price of oil as being $57.71 which represents a 45% reduction.

For completeness the price of Brent crude fell by $1.83 to $61.85 a barrel which is the lowest it has been since July 2009.

The fall in the price of oil represents a belief among ‘the informed’ that economic recovery is in danger of stalling and that the world is about to enter another period of decline.

This is precisely what the International Energy Authority (IEA), the world energy watchdog and OPEC have suggested recently.

The IEA published its latest monthly report on Friday which stated that it believes that the demand for oil in 2015 will fall by 230,000 barrels a day to 900,000.

It is worth noting that this is the fourth time in five months that the IEA has lowered its expectations.

The reasons for pessimism by the IEA and OPEC is based on their analysis of data showing that it’s going to decidedly much tougher in the immediate future.

For starters, China, viewed by many as an ideal export market, is slowing down economically.

I attended a seminar recently at which the speaker, an expert in Asian economies, asserted that the China is experiencing an economic decline which is far greater than we expected and that the incredible pending dedicated to urbanisation that is leading to fantastic speculative returns on property, may lead it to becoming the next Japan.

The news from our current biggest export market, the Eurozone, is also pretty bleak.

Economic data emerging from Greece and Italy show that they are back in trouble and that even the likes of Germany is, relative to its recent position, cooling off.

As many commentators are suggesting, what can the Eurozone do to stimulate demand given that the inflation is pretty much zero?

Oil’s falling price may simply depress demand causing inflation to fall below zero in a number of Eurozone countries.

And as retailers have discovering in recent years consumers will not buy something today if they realistically believe it will fall in price in the future.

The fall in the price of oil is being matched by falls in share prices.

That ‘clever’ money believes we should expect to a return to recession is, of course, horrendous especially as we’ve not recovered from the last one.

2015 is seven years on from 2008 which means that it will have been seven years which is significant as this is long believed to be the typical period for an economic cycle.

So, it might be asked, what can be done?

Crucially, given the UK economy is so dependent on personal spending, what will happen if we go into a deflationary dip?

This situation would certainly provide sound logic to stimulating consumption through increased monetary supply (more ‘quantitative easing’) though it is moot question as to where the money required would originate.

Many eminent economic commentators believe that avoiding depression, a possibility that is all too possible so soon after the last overwhelming shock to the economy, should be avoided whatever the cost.

Ben Bernanke who served as chairman of the Federal Reserve, the central bank of the United States from 2006 to 2014, is regarded as seminal for his role in the US economy in the aftermath of the credit crunch.

Bernanke implemented economic stimulus specifically to avoid repeating the mistake of the Federal Reserve in the Great Depression when money supply was reduced and interest rates were raised too soon.

If the current price of oil tells us anything it is we urgently need to avoid going into a state of stagnation caused by economic slowdown, falling inflation and vastly reduced consumption.

To achieve this would need a Keynesian approach to spending as was implemented under Labour chancellor Alistair Darling who followed Bernanke’s example.

The febrile debate concerning spending plans after the next election means that none of the major political parties will consider stating this as an economic policy.

The thing is, the oil price data strongly suggests that the world economy is about to hit tough times.

Waiting to see what happens may be too late.

Worse, the policy of savagely cutting spending may exacerbate the economic impact we experience.


Graeme Brown
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