This is the first of a regular series of columns from economist Tim Leuning.
January is the time for predictions. Every year economists make them. Sometimes we are right, and sometimes wrong. Some predictions, like inflation, are easy, but others are not. The oil price is not.
For fifty years, 1921-71, the oil price was fairly stable at c. $20 a barrel (in today’s terms). That was surprising: the price yo-yoed in the mid-nineteenth century and was fairly volatile 1880-1921. But neither the booming 20s nor the great depression, a world war, nor a post-war boom seemed to affect oil prices at all. Oil prices were one thing you just did not have to worry about.
That changed in the 1970s. Oil rose first to $50, and then to $100 in today’s terms. The effects were huge and many policy makers handled it badly. By the 1990s oil seemed to settle down again, with prices remaining around $20 in the mid-90s, rising to the mid-$20s as the century ended. And then, from 2002 we have 5 years of relentless rises to reach $100 again.
So the question is, will it continue? And why aren’t we suffering as we did in the 1970s? The first question requires a prediction, the second an explanation.
My prediction is that oil prices will not end 2008 materially higher than they are today, and that they will be at least a third lower in 5-10 years. The second prediction is the stronger. Oil prices at today’s level are unsustainable because there is plenty of non-OPEC oil in the world that is highly profitable to extract at $100 to the barrel – indeed, there is plenty that is profitable to extract at $50 to the barrel. Canada has the second highest oil reserves after Saudi Arabia, but Canadian oil is in oil shale, which costs $40 a barrel to extract. For years Saudi Arabia made good money extracting oil for a $1 and selling it at $20; if the oil price were $60 then Canada could make similar money. The fact that Canada can produce oil profitably at $50-60 makes it hard for oil to stay above $60 in the medium term. If we know that oil prices will be lower in 2013-2018 than they are today, the question is, when will they turn?
That one is harder. But there are three reasons to think that the turning point will be soon. First, the global economy is softer, and the strength of demand pressures has been one of the biggest causes of rising oil prices. Second, the current US administration will become increasingly powerless as the year goes on, and will be replaced by a less militaristic one in November. That will reduce fears about Middle-Eastern security, and also about Venezuela. Brown appears less militaristic than Blair, and Sarkozy’s approach to Russia shows that he is keen on energy flowing. China will not destabilise an oil country. The big risk, as ever, is that Saudi Arabia, or another major Middle-Eastern oil producer could fall victim to terrorist attacks, either in the oil fields, or at national level. But it is not a large risk.
So why are Western economies not suffering from the $100 barrel? There are two reasons. First, the energy intensity of the economy has fallen dramatically. British output per head doubled between 1970 and 2001, but our energy use per head rose only 6%. Broadly speaking we halved the economy’s energy intensity, so that an oil price shock hits us only half as hard as it once did. Oil would need to hit $200 a barrel to have the same effect now as $100 did in the 1970s. That is very unlikely. Second, the original price spikes came when OPEC turned the taps off, and decided to auction the oil they had. This price spike comes primarily because of high demand, mainly from China. But high Chinese oil demand stems from China growing quickly, and that reduces inflationary pressures, since cheap Chinese goods are replacing more expensive goods produced elsewhere. The lack of oil-led inflation means that central banks have not had to increase interest rates and that we have avoided recession. Indeed, all the talk is of interest rates coming down, not going up. Interest rates coming down below 5% with oil at 1970s levels, and without an inflationary boom? We live in a different world to that which Antony Barber and Denis Healey had to deal with. And three cheers for that!
Dr Tim Leunig teaches at the London School of Economics. His predictions, along with those of other economists, can be found here.