The Global Impact of Rising Oil Prices

Crude oil hit an all-time high early in April, topping $58 a barrel — and giving economists and financial-market analysts the shakes.



Is an oil shock likely? And, given the enormous demand by China and other rapidly growing economies, is there any chance oil will drift back to comfortable prices in the $30 to $40 range? Knowledge@Wharton, China Knowledge@Wharton, and Universia Knowledge@Wharton interviewed experts in the U.S., China, Spain and Brazil for their perspectives on the impact of high oil prices on the world economy.



Love Affair with Gas Guzzlers


Price forecasts cover a wide range, and most analysts concede the future is especially cloudy. The International Monetary Fund recently said it expects oil prices to rise by 23% during 2005, and then fall about 6% in 2006. After setting the record on April 4, oil fell back to about $50 by mid-month.



Amidst the volatility and uncertainty, two things are fairly clear: A number of market forces are working to prevent a dramatic decline in prices, yet the situation is not as bad as record prices seem to suggest. “Increases in oil prices are not good for the economy,” said Wharton finance professor Marshall E. Blume. “In the early 1970s, we had very substantial increases in oil prices due to the [Arab] embargo. In that case we had price controls, which really disrupted our economy.” While a surge in oil prices harms virtually all consumers and industries, it is especially hard on big fuel users like truckers, airlines and plastics makers, Blume added. “Think of automobiles. People will be more reluctant to buy gas guzzlers, and our economy is set up to build gas guzzlers.”



Nonetheless, according to Wharton finance professor Jeremy Siegel, the recent record prices are not as bad as they look. “The major reason for that is we have become much more energy efficient.” Today, he said, it takes less than half as much fossil fuel to produce a dollar’s worth of gross domestic product as it did in the 1970s. In addition, the U.S. economy is more diversified than it was three decades ago, with less reliance on energy-demanding manufacturing and more on service industries, which use less energy per dollar of output.



Moreover, recent oil price peaks, while records in dollar terms, are far short of the 1970s prices when adjusted for inflation. To match those records, oil would have to soar to $90, Siegel said. “We are nowhere near that yet. Now, $90-a-barrel oil. . . That would get people’s attention.” People did take notice when an analyst for Goldman Sachs investment bank said recently that oil would hit $105 in 2007, although he thought $50 more likely for the next year or so. However, a few analysts have suggested it won’t be too long before oil is again below $40. Nobody knows.



Siegel and Blume say there aren’t many reasons to think oil prices can fall quickly. Oil supplies, for example, are not likely to increase dramatically in the near term. Higher prices can spur exploration and make it profitable to extract oil from known fields where pumping is difficult and expensive, but many known reserves are already producing near capacity. “The ability to increase oil production dramatically from traditional wells is beginning to become a limiting factor,” Siegel noted. Non-traditional reserves, such as huge tar fields in Canada, will need billions of dollars of investment over many years to start producing significant supplies.



On the other side of the equation, he added, demand is not likely to drop. “We know Americans love their big cars.”



The China Factor


Meanwhile, the world market is dealing with a major issue — China. “Countries like China are going to increase their demand for oil,” Blume said. “That will certainly add to the price pressure.” In Siegel’s opinion, China “is quite formidable. The country is using a lot [of oil] . . . and has billions of dollars to spend on it.” Wages are so low that China’s industries can turn profits even if oil prices continue to rise, so it is unlikely that demand for oil will level off. “I see nothing stopping their economic growth because, basically, where are the bottlenecks?”



China is shifting tens of millions of workers from inefficient state-owned enterprises to vibrant, privately owned ones, according to Siegel. The huge labor surplus will keep wages low, and China has yet to fully exploit big potential markets in Europe. The country can boast “unlimited labor resources and dollars to build the capital and buy raw materials to produce goods for the rest of the world,” Siegel said. “I don’t see anything stopping it.”



With oil supplies limited and world demand growing, the U.S. economy is likely to suffer some damage, at least in the short term, Siegel predicted. High oil prices are among the key factors that have caused most economists to scale back their forecasts for U.S. economic growth in the rest of 2005. “Increases in oil prices are not good,” Blume added. “Things which are not good will reduce the economy’s growth rate and the employment growth rate. . . . We could still be growing, but not as fast.”



Most economists think the U.S. economy grew at a strong 4.5% to 5% annual pace in the first quarter, but the consensus calls for a 3.5% pace the rest of the year, Siegel noted, adding that much depends on consumer psychology — and consumers’ willingness to keep on spending. “I think economists have been surprised at how little oil has slowed down the economy thus far. Only now are we beginning to see some consumer reaction. . . . We may have reached a threshold where, from this point onward, it is going to hurt.”



A key factor may be gasoline prices this summer, which many experts expect to hit new highs, according to Blume. American refineries are already producing about as much gasoline and other oil products as they can. “There just haven’t been new refineries built in any large measure, or even the old ones upgraded, because of regulatory and environmental concerns,” he said. So even if oil supplies were to increase, supplies of oil products probably would not grow substantially. Hence, prices for gasoline and other refined products could well stay high. Higher oil prices spur inflation, leading the Federal Reserve to push interest rates up, which in turn can cause credit cards, car loans and mortgages to become more expensive.



All of this sends ripples through the financial markets.



Rising inflation tends to hurt bond prices, but it also dampens economic growth, which can help keep interest rates down — which is good for bonds, Siegel noted. “When oil goes up, bonds go up, because growth slows.” But it’s not the same for stocks. “Higher oil prices are an unambiguous negative for the stock market.” Higher oil prices raise production costs and leave customers with less to spend. Both undermine corporate earnings, which are the key to stock prices.



However, Siegel added, oil prices did fall slightly after hitting highs early in April. It’s not certain that oil will be more costly at the end of the year than it is now. “I am optimistic. There are always threats. If oil can stay at this level, or go down from this level, I think we have a chance at good growth for this year.”



The View from China


According to Lu Wei, an economics expert at the Development Research Center  of the State Council of PRC, rising oil prices will encourage energy conservation, affect China’s domestic energy consumption and change its industry and product structures.



In terms of supply and demand, international oil prices are not likely to sustain their gains because there are sufficient oil reserves globally to meet demand, Lu said. While a surge in regional demand in the short term may lead to a jump in prices, global oil prices eventually will stabilize at a certain level.



Nor will the hike in oil prices have too big an impact on the Chinese economy, mainly because China’s energy structure is different from that of the U.S., Lu noted. China, for example, isn’t as dependent on oil: Coal accounts for more than 65% of China’s energy consumption. In addition, the country is a major oil producer, with about 65% of its gasoline supplied domestically. Meanwhile, a rise in oil prices may push China to diversify its energy sources and increase the use of alternative energy. The country recently introduced a bill on renewable energy to promote such use. China also is changing its electric power structure and has begun the development of nuclear power.



Chen Hwai, director of The Center of Policy Research at China’s Ministry of Construction, said changes in the currency market are the real reason behind the current oil crisis. A depreciating U.S. dollar has pushed up oil prices, which are based in part on the dollar. Worldwide oil supply and demand is in balance, Chen stated, adding that there is no shortage crisis. Russia still has plenty of oil to sell, while demand from China isn’t heavy enough to tip the balance of global supply and demand.



According to Chen, it is incorrect to blame rising oil prices on demand from developing countries such as China. Oil prices are influenced by multiple factors, including the situation in Iraq, the status of Russia’s oil exports, and U.S. relations with Europe.



Dong Hsiu-Chen, a professor on oil economy at the University of Petroleum, China, agreed that a lower U.S. dollar plays a big role in the rise of gasoline prices. And while the nominal price of gas is near an all-time high, it won’t have the same kind of impact on the global economy as did the oil crises of the 1970s and 1980s, he noted. Nor does he see any signs of higher oil prices sending the world economy into a tailspin.



But because China, India and other countries are developing aggressively, their economic progress will be suppressed somewhat by higher oil prices, according to Dong. China’s domestic oil prices are linked to the international market. Within China, oil is consumed as a fuel source, and its derivatives used as chemical components in many manufacturing processes. Higher oil prices will be reflected in all downstream costs involving oil-derived chemicals. Therefore, higher oil prices will ultimately fuel inflationary pressures in China.



On the other hand, higher oil prices will also encourage China to transform its economic model and focus more on light industries instead of on oil-dependent heavy industries.



China’s present GDP to oil demand ratio is too great, according to Dong. For every 1% increase in GDP, oil demand increases by 0.65%. In his opinion, China must transform its economy, accelerate changes in its demand structure for energy, and develop new energy alternatives such as liquified coal, natural gas and ethanol gasoline. Dong doesn’t believe oil prices will increase by as much as Goldman Sachs analysts predict, rising to an astonishing $105 per barrel. Western countries’ current dependence on oil is less intense than it used to be, and meanwhile, many regions in the world may yet discover new oil reserves. China is also surveying its vast western region, along with its coastal regions, for oil deposits. “I’m not pessimistic about oil prices because while worldwide demand is steadily increasing, supply ability is gradually improving, too,” Dong said.



Oil Prices and the Euro-zone


Asked for his views on the current oil crisis, Juan Antonio Maroto Acín, professor at the Complutense University of Madrid, described the situation as “serious, because both demand and supply are showing great rigidity when it comes to adjusting to signals emitted by prices.  In addition, from the supply side, there is no conventional cause that explains the current crisis, unlike previous shocks, which were justified by scarcity or by a reduction in supply. Moreover, developed countries have not made any meaningful reduction in their demand for oil as a result of rising prices. What’s worse, the explanation offered so often — greater demand by China — is becoming less convincing given that country’s decline in oil imports in 2005. And finally, the situation is getting worse as a result of growing price speculation on the oil futures market.”


According to Maroto Acín, it’s difficult to assess what impact the rise in oil prices will have on the European economy, given Europe’s high level of demand. “It’s not just that prices rose by an average of more than 32%, in dollar terms, during 2004. Abrupt short-term fluctuations are also continuing, making it unfeasible for companies to draw up any plans based on expectations. In addition, you have to take into account the weakness of the euro-zone economy’s current recovery. It means that business activity will feel the impact in coming months.” In Spain, for example, the result will be a drop in exports. “We are already seeing that happen with Spain’s exports to Europe, our largest export destination,” he said.



“Currently, Spanish companies are more dependent on petroleum than companies in the U.S., Japan and the other countries of the euro-zone, except for Greece, Portugal and Ireland,” Maroto Acín noted, adding that demand for oil in Spain has soared in both the transportation and consumer sectors, including automobiles. “That will motivate several groups of professionals — transportation workers, farmers, taxi drivers — to demand subsidies for the products they use. In some cases, they will demand higher salaries to cover the loss of purchasing power that results” from higher home energy bills.



There is also the “added risk of a medium-term impact on interest rates,” he pointed out. “Their current low levels are justifying both the improvement in Spanish corporate earnings and the high level of corporate indebtedness. If rates rise, the economy will feel the impact, as will the savings of Spanish families, who are highly indebted and have mortgages that they can meet only if interest rates remain at their current levels.”


Efforts by governments to contain the growth in oil prices are not “really effective” except that governments are “beginning to understand the problem and evaluate how they can control financial speculation,” Maroto Acín added. Meanwhile, “the required revival of demand is based too much on private-sector consumption. It does not look like there will be a change in the way petroleum products are consumed.” Other measures would be more effective for Europe, he said, such as upward revaluation in the currency of China and other Asian countries. Those currencies are artificially pegged to the dollar, which means they are financing the U.S. deficit and destroying entire industrial sectors, such as textiles.”


As for predicting the future, Maroto Acín said that “to be credible, predictions must be based on a consensus of everyone involved, and we are far from achieving that. Over the next few months, energy-producing countries are planning to increase supply but people doubt they will do so, given continuous price fluctuations, which are resulting more from financial speculation than from demand signals. Developed countries and net importers of crude oil are already making plans to deal with oil prices that reach $80 or even $120 a barrel. That would lead to a spectacular reduction in [economic] growth and an equally spectacular growth in inflation. Already, the IMF has estimated that an oil price of $52 per barrel will reduce global growth by as much as 0.5% in 2005.”



Oil’s Future in Latin America


Edgar Luiz Fagundes de Almeida, professor at the Institute of Economics of the Federal University of Rio de Janeiro and a member of that institution’s Energy Economics Group, argues that the oil crisis at this time “is not a great cause of concern. The oil price increases are still compatible with trends in the purchasing power of consumers, and the impact on companies’ costs is still not very serious. The price of a barrel of petroleum has been above the $30 to $40 mark for more than two years, and the global economy has continued to grow.”



However, De Almeida adds, that will change “if there is very serious political instability in the Middle East. The war in Iraq did not have a significant impact on the global supply of oil. Iraq had already been virtually outside the oil market. But the situation helped to raise prices quite a bit. Furthermore, if there were a problem in producing nations such as Venezuela, Saudi Arabia and Russia, we would have a serious crisis in the global oil market and a shortage of supply. But for now, the situation is still under control.”



What matters to the economies of Latin America, he added, “is whether the U.S. has to adjust its external accounts by raising interest rates and the cost of capital. In reality, our region is a major importer of capital; it depends on capital as an ‘input.’ We are not dependent on oil; we are dependent on dollars. So, to the extent that oil prices rise, that has a harmful effect on our region’s potential for economic growth.”



Governments, De Almeida said, “are now more interested in developing alternative sources of energy” and “more worried about the issue of securing their supplies of energy. . . . Therefore, governments have a greater incentive to use alternative energy sources” and increase their R&D investment in this area. Having said that, De Almeida doesn’t think that governments can claim much success with these initiatives. “The price of oil is the factor that will really determine if there is an inflexion on the demand side. Price levels will also determine, eventually, if there is a more aggressive effort made to find substitutes for products that are derived from petroleum. If the price of oil continues at current levels, those policies will have only a marginal impact.”



As to whether high energy prices will raise inflationary concerns, “the global economy is already experiencing increased costs,” De Almeida said. “But for the moment, these increases should not cause much concern. Interest rates have not changed much as a result of inflation, either in Europe, the U.S. or Japan. In the U.S., the adjustment in rates is a function of the external deficit. Oil prices have not yet had a very significant impact on inflation. However, inflation can become a problem if oil prices rise to much higher levels in the future.”


The positive side of rising energy prices is that “at least our region has a high potential for oil production — in Venezuela and Brazil,” De Almeida noted. “Investors are more interested in Latin America. The attractiveness of our oil and gas sector is growing. On the other hand, the economic potential of alternative energy sources is also growing. Now, for example, there are bio-diesel fuels. In Brazil, you see a very strong expansion in the use of these fuels in vehicles.  All of this makes those kinds of energy sources more competitive with petroleum.”

Citing Knowledge@Wharton

Close


For Personal use:

Please use the following citations to quote for personal use:

MLA

"The Global Impact of Rising Oil Prices." Knowledge@Wharton. The Wharton School, University of Pennsylvania, 10 May, 2005. Web. 28 November, 2014 <http://knowledge.wharton.upenn.edu/article/the-global-impact-of-rising-oil-prices/>

APA

The Global Impact of Rising Oil Prices. Knowledge@Wharton (2005, May 10). Retrieved from http://knowledge.wharton.upenn.edu/article/the-global-impact-of-rising-oil-prices/

Chicago

"The Global Impact of Rising Oil Prices" Knowledge@Wharton, May 10, 2005,
accessed November 28, 2014. http://knowledge.wharton.upenn.edu/article/the-global-impact-of-rising-oil-prices/


For Educational/Business use:

Please contact us for repurposing articles, podcasts, or videos using our content licensing contact form.

 

Join The Discussion

No Comments So Far