Oil spike impact may not be as bad as before

Economics: The price of oil is off the recent highs. Brent crude, the benchmark for the European market, traded below $50 (€59.65) a barrel, from an all-time high of $51.50 earlier in the month, and may decline further, although it remains to be seen whether this pull back is temporary or not.

For now the market is pricing crude oil at more than $45 for delivery in a year's time, so a rapid return to the sub-$30 levels seen in recent years is not expected, at least by market participants.

Apart from the uncertainty about the next major price move, an important question is why oil prices of this magnitude have not had a more pronounced impact on the global economy.

As a rule, a $10 rise in the price of oil can be said to reduce growth by around 0.5 per cent while adding a similar percentage to inflation. The price of crude oil in the US has averaged $40 year to date, against $31 in 2003, implying that growth there may be half-a-per cent lower than it might have been. Of course, if oil stays at $50 and above, the implied impact is even higher, perhaps amounting to a full percentage point off economic growth.

Yet the US economy has clearly accelerated in recent months, with growth in the third quarter seen as high as 5 per cent at an annualised rate, from 3.3 per cent in the second quarter.

So the growth impact does not appear to be significant, at least for the moment, which may come as a surprise to those old enough to remember the oil price shocks of the past. Then the impact was seen as much more severe with received wisdom associating high oil prices with global recession.

One difference is the magnitude of the increase: from 1973 to 1974 oil prices rose by more than 250 per cent and between 1978 and 1980, the rise in price was 180 per cent. Since 2003, the oil price has risen by around 80 per cent - which is strong but not on the same scale as previous episodes. This may partly explain why the growth impact was much more significant in the 1970s, reducing output by 2-3 per cent.

Also, past spikes in oil prices stemmed from supply shocks, with crude output curtailed for political reasons or by OPEC, whereas the recent run up in prices owes far more to the global economic boom.

That's not to say that supply considerations have not made an impact - Iraqi supply has been interrupted, and weather and strike activity has also had an impact elsewhere - but there has not been a prolonged period in which a substantial share of global oil production was out of action. Indeed, it is now generally believed that there is very little short-term capacity available in the global oil market, which explains the exaggerated price impact following any perceived supply interruption or risk to capacity.

The scale of demand is also seen in other areas of the oil market, including the spread between the respective US and European benchmarks. The former normally trades at a premium because it is lighter and sweeter but that premium has recently widened, to more than $4, against a longer run average of less than $1.50. This implies special factors at work in the US and this is supported by the recent widening of the spread between refined product and crude oil, which highlights strong demand for petrol and heating oil, and a shortage of refinery capacity.

Moreover, a raft of different clean air regulations across the various US states exacerbates the refinery problem, as a shortage in one state cannot be rectified by simply shipping in fuel from a neighbouring state.

From an Irish perspective, the price of crude oil has averaged around $37 year to date, against more than $28 in 2003, but this needs to be adjusted for the appreciation of the euro, which has offset to some degree the dollar rise in oil prices.

In euro terms, the price of oil has averaged €30 year to date, against €25 for 2003, and this moderate rise is one reason why the oil impact has not been pronounced. Another point relates to the high share of tax in fuel prices, with excise duty and VAT accounting for some two-thirds of the price of petrol at the pump in the Republic, against some 25 per cent for the refined oil.

This also helps to explain why the rise in petrol prices has not been as large as implied by the move in crude oil prices. For example, petrol averaged 87 cents a litre in December 2003 according to the Automobile Association, and averaged 99.5 cents in September, a 14 per cent rise. The price of crude rose by some 55 per cent over that period in euro terms, which should translate into only a 14 per cent rise in petrol prices, all things being equal, given the low share of crude in the final petrol price.

Dr Dan McLaughlin is chief economist at Bank of Ireland