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Paying the price

By Donal Curtin

Friday 14th October 2005

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As you and I fork out $1.50 (or more) for a litre of petrol, it's understandable that we are all looking at the downside of the soaring oil price. And there are also some good reasons to be worried about its wider impact, beyond that on our own wallets: there's a good case to be made that forecasters are currently over-complacent about the risk that oil at US$65 a barrel poses to the world economy.

Consider this: a year ago, The Wall Street Journal, which regularly surveys a panel of 56 economic forecasters, asked them what level of oil prices would push the US economy into recession. Roughly a third of the forecasters believed that oil prices in the US$50-59 range would be enough to tip America into recession, and another third believed prices in the US$60-69 area would do it. In other words, two-thirds of the forecasters believed that oil at today's prices would cause an American recession. Only a minority thought it would take prices higher than today's to do it.

The Journal asked the question again, in April of this year: at that point oil had risen into the US$50-55 range. Rather oddly, the forecasters had changed their view.

Despite their earlier assessment, now nobody in the panel thought prices in the US$50-59 area were an issue. And three-quarters of the panel now believed it would take oil prices above US$80 a barrel to do serious damage. Given that not a terrible lot had changed elsewhere in the US economy to warrant this 180-degree change in view, you have to conclude that current forecasts of economic growth and corporate profits in the developed world may not be as connected to the real world as they ought to be.

There may, in short, be some complacent optimists out there - but, that said, things aren't as bad as the alarmists think, either.

In an odd way, the strength of the oil price is actually a symptom of some good news: the strength of the booming Chinese economy. China on its own has accounted for one-third of the world's increased demand for oil in the past year - hardly surprising, when you've got an economy of 1.3 billion people growing consistently at 9% a year.

What we're seeing, in short, is no more than the normal operation of supply and demand. Just as we had the $5 avocado earlier this year when supplies failed, now we've got the $1.50 litre as demand has surged. And (despite the fatheads calling for government action to lower the petrol price) this is how the world works best - when markets allocate scarce stuff to those who value it most highly.

Nor have the greenies, with their "prices are soaring because the oil is running out", got the right end of the stick. Even before this latest increase, oil prices were high enough to have triggered a surge in exploration and development. Cambridge Research Associates, who are respected energy market analysts, have estimated that world oil production will rise by 20% over the next five years as projects are completed everywhere from the Caspian Sea to Angola. There'll be even more projects viable at today's prices. And it's worth recalling that we've seen exactly this sort of supply-side response before: when oil prices quadrupled in the 1970s, from US$4 to US$16 a barrel, it brought the whole of the North Sea's vast hydrocarbon reserves into play.

What doomsayers forget is that price incentives can be very powerful over the long-term. It's true that in the short-term we're all stuck with the way things are today: it's not usually possible to rip out the diesel-fired plant in the morning and be running on solar energy in the afternoon. But the long-term is a radically different story. As noted earlier, you get very strong supply-side responses, and you get equally dramatic demand-side adjustments. It's worth pointing out that for all its gas-guzzling image, the US, today, uses half as much energy per unit of real GDP as it did in 1980. That was a huge shift in usage in response to the OPEC shocks, and, in time, we'll see the same response to this latest surge.

Finally, it might be worthwhile to spare a thought for the ghost of former prime minister Sir Rob Muldoon. Some of his Think Big ideas weren't that good, and many of the projects were pitifully executed, but the overarching strategic idea of developing our own energy resources, with the benefit of hindsight, is looking pretty good. Somewhere, there's a portly spirit presence cackling, "I told you so".

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