Overnight there has been plenty of bad news with the natural disaster of an earthquake in New Zealand following the man-made one in Libya where events reached a nadir of fighter jets bombing their own people as the regime clings desperately to power. My sympathies are with the killed,maimed and injured in both events. If we move onto the economic impact of this we can see that the first effect has been on the price of crude oil which has soared. This is driven by two factors. Firstly is the fear that the problems may spread to other autocratic oil-producing countries in Africa and Arabia of which there is no shortage and the second is that Libya herself is a reasonably substantial oil producer. According to the Energy Information Agency.
Nonetheless, crude oil capacity has increased somewhat over the past decade from 1.43 million bbl/d in 1999 to 1.8 million bbl/d in 2009. Crude oil production in 2009 was approximately 1.65 million bb/d, about 150,000 bbl/d below capacity but still above the production quota set by OPEC which is currently at 1.47 million bbl/d………..With domestic consumption of 280,000 bbl/d in 2009, Libya had estimated net exports (including all liquids) of 1.5 million bbl/d.
So as you can see Libya is quite a substantial oil exporter as her own consumption is quite low and she mainly exports to Europe with Italy as the largest consumer. As the unrest spreads it seems ever more likely that most if not all of her oil production will shut down and there is also the danger of her production facilities being damaged in the fighting.
The Price of Crude Oil Surges
In response to fears about a production fall in Libya and possible unrest elsewhere (Saudi Arabia for one) the price of crude oil surged yesterday and is strong again this morning. A barrel of the West Texas Intermediate benchmark cost US $86.20 at Friday’s close and is now at US $93.90 for a 8.9% rise over the period. The price of a barrel of the Brent crude benchmark has risen from US $103 to US $107.67 over the same time period.
As long as this unrest goes on we can expect the oil price to be strong and as it ebbs and flows we are likely to see a high level of volatility. We can expect the seeds of this unrest to sprout in other places so we may have to live with an inflated oil price for some time. Should it turn out to be sustained I thought that I would look at the economic impact of a higher oil price.
There have been several attempts to measure the impact of a rise in oil prices on the world economy and they show broadly similar results. One of course has to be careful with the assumptions used and take them as a general guide rather than taking the numbers as a gospel truth as all types of econometric analysis suffers from the flaw that you cannot stop the world economy and just change one variable and see what happens! But the results are rather revealing I feel. I looked at this subject back on the 6th of April last year and here is the analysis.
1.When the prices of petroleum products increase, consumers use more of their income to pay for oil-derived products, and their spending on other goods and services declines. The extra amounts spent on those products go to foreign and domestic oil producers. In effect this is deflationary ( I define this as a fall in aggregate demand/economic output and do not refer to falling prices).
2. Higher oil prices cause, to varying degrees, increases in other energy prices. Depending on the ability to substitute other energy sources for petroleum, the price increases can be large and can cause macroeconomic effects similar to the effects of oil price increases. In effect this is inflationary particularly as it feeds through the economy.
3. Oil is also a vital input for the production of a wide range of goods and services, because it is used for transportation in businesses of all types. Higher oil prices thus increase the cost of inputs; and if the cost increases cannot be passed on to consumers, economic inputs such as labor and capital stock may be reallocated. Inflationary and possibly deflationary again.
4. Because most industrial countries are is a net importers of oil, higher oil prices affect the purchasing power of their national income through their impact on the international terms of trade. So generally deflationary here.
5. Changes in oil prices can also cause economic losses when macroeconomic frictions prevent rapid changes in nominal prices for final goods (due to the costs of changing “menu” prices for example) or for key inputs, such as wages. Because there is resistance on the part of workers to real declines in wages, oil price increases typically lead to upward pressure on nominal wage levels. Moreover, nominal price “stickiness” is asymmetric, in that firms, unions, and other organizations are much more reluctant to lower nominal prices and the wages they receive than they are to raise them.
So there are five main mechanisms which affect a typical industrial economy from a rise in oil prices. There are variations between the exact effects if for example you compare Japan which has no oil to the UK which became a net oil importer in 2005/06 but still is a producer itself.
Also effects are impacted by how well economic policy in the country or countries concerned responds. The actual state of the economy in the first place also matters as for example one with pre-existing inflation is likely to be disproportionately affected by an oil price rise. Also if an oil price move is sudden and large (often called an oil price shock) it is likely to have a more substantial impact than a move gradual move.
Economic output (GDP): falls by 0.4% in year one and by 0.4% in year two
Inflation: rises by 0.4% in year one and 0.5% in year two
Unemployment: rises by 0.1% in year one and by 0.1% year two
Another impact of this is that there is a large transfer of wealth/economic income to the oil-producing nations of the order of US $150 billion. Happy days for OPEC, much less happy for most other countries.
An Immediate Thought for the UK and the Bank of England.
I think there is a lot of food for thought in this section because should this rise in the oil price be sustained it will mean that both the condition below are being fulfilled.
The actual state of the economy in the first place also matters as for example one with pre-existing inflation is likely to be disproportionately affected by an oil price rise. Also if an oil price move is sudden and large (often called an oil price shock) it is likely to have a more substantial impact than a move gradual move.
I have warned many times that, in my view the Bank of England is playing a dangerous game in the way it has let inflation back into our economy. The danger always was that something else kicks it off. The irony is that it is something that might actually be a one-off shock. The problem is that we are starting from the wrong position of already rising inflation and are in danger of repeating many mistakes from the past. If inflationary fires are to start gathering more strength in the UK then we have some petrol to pour on the flames now.
The European Central Bank takes a different view on inflation
Over the past few days we have seen several members of the Governing Council of the ECB say that inflation is a concern to them and that in spite of the problems in the peripheral nations they are willing to raise official interest-rates in response. The real driving force behind this has been the economic recovery in Germany and the fact that inflation in the Euro zone is now above target. If we look at the Markit Purchasing Managers Index figures from yesterday we saw that output .
rose from 57.0 in January to 58.4 in February. The latest reading signalled the strongest monthly expansion since July 2006 and one of the strongest growth rates in the near 13-year history of the survey.
So strong output but also strong and accelerating inflationary pressures.
Prices charged for goods and services rose at the fastest rate since July 2008, showing the largest monthly acceleration since data for this series were first collected in 2002. Manufacturers’ output prices showed a record rise while rates levied for services showed the largest monthly increase since August 2008.
Input price inflation meanwhile also jumped higher, reaching the highest since July 2008. A record (near 14-year) high in manufacturing was accompanied by the steepest rate of increase in services since September 2008. Higher food, energy, fuel, metals and other commodity prices were widely reported.
The numbers for Germany were even stronger.
So there you have it we are back to two-speed Europe with Germany surging and the periphery left behind. The politician’s of Europe have left its central bank with quite a problem that if we get high oil prices for a sustained period will only get worse. Project an interest-rate rise on this and yet again the periphery will suffer as interest-rates to suit Germany’s economy are applied.
Just to add to the problems facing the European Central Bank we found out yesterday that the week before last it bought some 711 million Euros of peripheral (Portuguese) debt. Does it intend to buy them all?
And Finally: Moodys downgrades Libya
This may not seem so unusual in the circumstances but as Moodys reacts as if on a hair-trigger one might wonder about the rush to downgrade a nation with zero foreign debt and a sovereign wealth fund worth around 130% of annual economic output (Gross Domestic Product)……..