What will the surging crude oil price do to UK and European inflation and their economic growth?

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.

How is the impact of a rising price of crude oil transmitted?
 In itself crude oil has few uses but demand for crude oil arises from demand for the products that are made from it—especially petrol, diesel fuel, heating oil, and jet fuel, as well as many materials such as plastics; and changes in crude oil prices are passed on to consumers in the prices of the final petroleum products. If we look at the impact of changes in the oil price on industrial countries we get five main transmission mechanisms where it impacts on the general economy.

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.

The Numbers: a US $10 rise in the oil price 
There have been many analyses of this undertaken and accordingly I owe thanks to the US Federal Reserve, the National Institute for Economic and Social Research,the International Monetary Fund, the International Energy Agency and Global Insight. So I have looked at general analysis and merged the numbers and taken a typical industrial country.

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.

Comment

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)……..

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9 thoughts on “What will the surging crude oil price do to UK and European inflation and their economic growth?

  1. Regarding the oil question: yes, I can see that a spike in prices may lead to a slow-down in UK and European growth. However, when viewing Libyan exports as a percentage of global needs it is comparatively minor and there is always the potential for other OPEC countries meeting any shortfall. Moreover, whether Libya changes her government or not, whoever takes over (eventually) will surely wish to keep the oil flowing as this is such a huge element of their overall GDP. A spike may be inevitable but a prolonged upward movement in the price is less likely, in my humble opinion.

      • Sorry, I have posted this in the wrong place somehow. It was meant to be at the bottom of the comments page, obviously, and not referring to this eminently sensible post!

  2. “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.” Absolutely, and the UK is particularly vulnerable, firstly in respect of crude fiscal drag and secondly in respect of already higher and rising inflation than in most regions. Total taxes levied on oil products in the UK are amongst the highest and most punitive in the world, so any increase in the real price of crude is reflected with significant leverage in for example the price of gas on the station forecourts due to this fiscal drag.

    Thus the effect of crude price rises upon the UK economy, already having uncontrolled inflation for some while and now rising, will be much more depressing than in most other countries, and will lead to at best a similar inflation scenario to that in the 70s, or at worst something much more devastating, which we have never experienced previously. An extremely grim future awaits for the UK I fear?

  3. Would be interesting to see the impact of the rising price of crude oil on the peripheral Eurzone countries considering the EU countries with the highest percentage of oil used in their total Energy Mix are in order: Greece, Ireland, Portugal, Spain and Italy. Which is a rather interesting coincidence.

  4. Drf and Jacob,
    You post some interesting comments and I admit my knowledge of the market is weak to say the least. However I did find some useful information at the link below:
    http://www.guardian.co.uk/business/interactive/2008/may/22/commodities
    Whilst I admit to it being somewhat outdated, it does show that the current price is similar to that of the 1980 level, even when adjusted for inflation. Yes I can see that a prolongation of uncertainty will lead to a price rise, but surely there are “buffer mechanisms” that can shield us from melt-down in any worse-case scenario? I look forward to your further views….

    • Hi Ray, Well of course no one can see into the future, accurately. It all depends as you imply in your second comment whether the instability becomes prolonged or whether it is just a flash-in-the-pan which subsides, and whether the crude price change mirrors that or not. An added variable in this mix is the concept of peak oil at a time when emergent economies are increasing their demand for and consumption of oil. (For example it appears that Saudi-Arabia has overstated its actual oil reserves by a significant amount?)

      An added variable is whether the current insurrection in a number of regions is a trend or just a flash in the pan? I fear these in fact are not just a flash in the pan! Essentially the West pouring in Monopoly money to save the banksters and to attempt to continue the excessive debit-based economy has now caused a spike in most commodity prices, including food. People will bear many misfortunes and discomforts, but when it comes to being hungry and their families being hungry there will always be a flash-point once the choice is either dying from hunger or dying from fighting in riots to overthrow the regime which has caused or allowed the hunger.

      I do not believe that such insurrection will be confined to the middle east or emergent nations. If things continue as they are I can see similar discord coming to the USA and Europe; (we have already seen practical evidence of it). The USA administration clearly has prepared for such an eventuality with specific confinement camps and cheap coffins piled high in readiness.

      So, as I pointed out, no one can foresee the future accurately, but if you look back at the 70s in the UK with inflation (officially admitted) reaching almost 30 % and real inflation probably being more like 38 % in one year, that is probably a good outline predictor of the possible scenario if unrest continues to cause crude to rise in price.

      • Thank you very much indeed for such a lucid response and in terms that are easy for anyone to understand and follow. You paint a horrific scenario far worse than anything experienced in my (longish) lifetime. I shall remember and value your views over the coming months – and years if we can still communicate!

  5. You write: 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?

    I comment: Yes there definitely is a two speed Europe. And if oil is sustained at a high price, great problems indeed. It very well may be that current price of oil is a spike; but it may be that a high relative price of oil could remain. Some 711 milliion Euros of Portugese debt is huge. An issue is that the sovereign debt of all nations is interwoven into the Ejuropean Financial Institutions. And an issue is that Portugal has lost its debt sovereignty and debt sovereignty. The ECB is now Portugals seignior.

    The fact that Germany is such a powerhouse and the fact that the ECB provides seigniorage, that is moneyness, to the periphery, means that a federal Europe is coming. Yes, there is a crisis dead ahead. The crisis is global and it has epicenters in regions throughout the world, ie Europe, ie the Gulf States, ie Africa, ie the US.

    In my article …. Gold And Silver Soar As Exhaustion Of Quantitative Easing Propels Stocks And Commodities Downward …. I write The recent fall in the Euro, FXE, from its November 2009 value of 149 strengthened exports from Germany and strengthened European manufacturing and service economic activity as a whole.

    EuroIntelligence in their for fee news service reports the purchasing managers index for the eurozone has reached new heights. The composite purchasing managers index in the eurozone, including manufacturing and services, expanded strongly during February to a level of 58.4, the highest since July 2006. The German sub-index rose to 62.6, the highest level since the beginning of the series in 1996. Germany’s Ifo index rose to the dizzy heights of 111.2, the highest level since German unification.

    Quantitative easing continued to exhaus today, a process that began with the formal announcement of QE 2 in November 2010.
    Michael Pento, senior economist at Euro Pacific Capital Inc. in New York, who correctly predicted the 2008 commodity-market collapse, relates: “Bernanke is not only off base with regard to inflation he’s off the entire planet” … “Inflation will go much higher … You can’t continue to have a reckless monetary policy and a government issuing endless quantities of debt and also have the supposition that you have the world’s reserve currency and low interest rates.”

    Exhaustion of quantative easing turned the World Financials, IXG, lower. The Brazilian Financials, BRAF, Australian Bank, Westpac Banking, WBK, India Bank, HDFC Bank, HDB, the European Financials, EUFN, led by Banco Santender, STD, and the Emerging Market Financials, EMFN, all fell lower, communicating an end to the seigniorage, that is moneyness provided by quantitative easing and the seigniorage of central banks globally. Confirmation comes from distressed investments like those in mutual fund, FAGIX, which constitute a large part of the US Federal Reserve’s balance sheet, and which served to underwrite the recovery of the last two years. Also the turn lower in junk bonds, JNK, from its recent high, and a topping out in world government bonds, BWX, serves as evidence to the end of US central bank seigniorage. Without seigniorage, stocks will fall precipitously world wide.

    Quantitative Easing Exhaustion has its epicenter first the airlines, FAA, struck by high oil prices, then the once red hot emerging markets, EEM, then coal, KOL, and now in the banks, KBE, and the too big to fail banks, RWW, then the basic material shares, XLB, and then the agricultural shares, MOO, and then the industrial, IPN, shares, The countries and stocks which first benefited from QE, are now falling, like dominoes all falling one upon another.

    The fall in the European Oil Companies ENI, E, and Repsol, REP, gives stark testimony that the once inflationary quantitative easing is now acting to deleverage profitable investments. In addition to the basic material late bloomers of the past rally, integrated circuit manufacturer, Jabil Circuits, JBL, which received a late dose of the QE cool aid, fell sharply. Diversified equipment manufacturer, CMI, fell sharply as well. And Design and Build leaders, Foster Wheeler, FWLT, and Fluor, FLR, fell sharply too.

    Gold, GLD, and Silver, SLV, and Precious Metal, JJP, exploded higher, as the US Federal Reserve’s monetary policies monetize the US Sovereign Debt and create an investment demand for gold.

    Oil, USO, and Brent Oil, BNO, and Gasoline, UGA, exploded higher on turmoil in Libya.

    Base metal prices, DBB, turned 3.4% lower, turning basic material stock, XLB, 3.2% lower with Aluminum, JJU, Copper, JJC, Lead, LD, Tin, JJT, and Nickel, JJN all turning lower.

    Timer, CUT, turned lower. Historically timber has been a fast faller.

    Food commodities, FUD, agricultural commodity prices, JJA, and, DAG, cooking oils, FUE, turned lower, with grains, GRU, and corn, CORN, seeing significant losses. These turned agricultural stocks, MOO, such as Monsanto, MON, lower

    Falling commodity prices, DJP, turned 1.0% lower, turning world stocks, ACWI, 2.7% lower

    Countries falling strongly today included the following:
    Gulf States, MES, 5.6%
    Italy, EWI, 5.6%, and Spain, EWP, 4.5% are once again deflationary leaders
    Africa, AFK, 5.2%
    Brazil Small Caps, BRF, 4.0%, Brazil, EWZ, 3.0%, and Brazil Financials, BRAF, 4.0%.
    China Technology, CQQQ, 6.0, Shanghai, CAF, 4.1%, China All Caps, YAO, 3.7%, China Small Caps, HAO, 4.5%, China Materials, CHIM, 3.7%, China Financial, CHIX, 4.0%, and China Real Estate, TAO, 4.1%.
    Korea, EWY, 4.0%, and South Korea, SKOR, 4.0%, fell lower on less export growth. Korea is a fallen Asian Tiger.

    The S&P, SPY, 2.0% The weekly chart of the S&P, SPY Weekly, communicates that the S&P entered into an Elliott Wave 3 Down today February 22, 2011.

    This bear market will be the bear market of all bear markets as seigniorage of the Milton Friedman Free To Choose Currency Regime, that being the distressed investments held by the US Federal Reserve, FAGIX, and US Government Bonds, TLT, and EDV, can no longer provide seigniorage, that is moneyness, to world stocks, VT, and world small cap stocks, VSS.

    The failure of the QE rally and the EFSF rally in stocks, is the consequence of the false stimulation that has come via quantitative easing and unrealistic values for European Financial Institutions.

    The misery of Ben Bernanke’s inflation that has come to hundreds of millions in higher food costs, and loss through cultural revolution is incalculable; but those owning gold and silver bullion can count their gains quite well.

    It just is non productive for capitalists to risk their capital digging around in the ground for new gold. Risk appetite turned to risk avoidance today. The price of existing gold will become more and more dear all the time, as is communicated in the chart of the gold relative to the Australian Dollar, GLD:FXA.

    Gold has arisen to be sovereign wealth and the sovereign currency. Stocks, bonds and and now fiat currencies, are falling into the pit of financial abandon together “as the where-with-all for investment has been undone by the bond traders calling the interest rate higher on soveign debt across the board”. that is higher on the 30 Year US Government Bond, $TYX, on the 10 Year US Government Note, $TNX, on emerging market bonds, and on world government bonds. The destruction of seigniorage, that is the destruction of moneyness, is seen in the fall in value of the 30 Year US Government Bond, EDV, the US Government Note, TLT, Emerging Market Bond, EMB, and World Government Bonds, BWX.

    The where-with-all since the last financial collapse has come via quantitative easing and quantitative easing 2. The seigniorage, that is the moneyness, came via an asset swap, where Ben Bernanke, traded out money good US Treasuries for distressed securities, like those traded by mutual fund FAGIX. For the most part, then the banks placed the US Treasuries into Excess Reserve with the Fed. The distressed investments, and the Excess Reserves have been the great springboard of investment growth, that is they have been the seigniorage for the stock expansion of the last two years.

    Today February 22, 2011, was a day that will live in financial and economic infamy, as quantitative easing failed, and the seigniorage of the US Federal Reserve failed, as the mutual fund FAGIX, and Junk Bonds, JNK, both turned down today, in accompaniment of falling stock values worldwide, ACWI. The United States, has lost totally lost its debt sovereignty, that is its debt and currency seigniorage.

    Soon there will come Gotterdammerung, an investment flameout, as US Government Treasuries, EDV, the US Government Ten Year Note, TLT, and World Stocks, ACWI, loose more and more value, Then out of the ensuing chaos a global Chancellor, that is a Sovereign, and a global Banker, that is a Seignior, will arise to establish global order, a new and universal Seigniorage with austerity for all.

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