Oil price conundrum

OECD Observer

The adverse effects of the oil price shock are currently working their way through. But will prices settle back, or are higher oil prices now a fact of life?

Provided oil prices do not rise above their assumed path, economic expansion should firm during 2005, with the OECD-wide output gap closing towards late 2006. At the same time, headline inflation should slow somewhat in the course of 2005-06, as the first-round impact of the shock fades and on the presumption that second-round effects remain limited. Unemployment will stay relatively high and international imbalances are set to worsen. Some of the near-term indicators suggest weakening momentum.

Partly reflecting the oil price shock and the related uncertainty, business confidence has softened in the United States since early 2004, albeit from high levels. In the euro area at large and Japan, it has improved, although it does not much exceed long-run averages.

The oil price could fall back significantly, consistent with the fact that, either way, spot oil prices appear to have been boosted by a number of short-run factors, but it could also turn out to be higher and more persistent than expected. Supply disruptions reducing daily output by no more than one or two million barrels could lead to substantially higher oil prices. The actual size of a possible further adverse oil price shock would, however, depend on its source, oil reserves being relatively concentrated geographically. Under the assumption that nominal interest rates are unaffected, our standard simulations suggest that a sustained $15 increase in oil prices – from the middle of the range targeted by OPEC in the past to $40 – subtracts some 0.2 percentage point from OECDwide real GDP growth in the first full year. They also point to a concomitant rise in consumer price inflation of a slightly greater magnitude. Such simulations do not capture possible negative effects, such as the impact a large price shock would have on confidence.

Have oil prices overshot?

A key question, of course, is whether higher oil prices will persist. Oil price volatility has increased gradually over the past decade and in this context, substantial spikes to the oil price are not particularly unusual. Over the same period, the persistence of oil price shocks has diminished, though it is difficult to predict whether an oil price shock is permanent or transitory. In this context, with oil prices in 2004 reaching levels that have not been seen since the oil price shocks in the 1970s and early 1980s, the question arises whether oil prices will remain this high or revert towards their (lower) longer-term trend.

Oil prices in short-term futures markets reflect temporary risk premia and speculation. With respect to the short-term futures price, the oil market has been in almost continuous strong backwardation since 1999, with the current (spot) price being significantly higher than the sixmonth futures price. This is an unusually long period for backwardation and suggests that current uncertainties are adding a large risk premium to the spot price.

During 2004, fears over the security of supply have surfaced with regularity. Indeed, risk premia have risen with fears of supply disruptions arising from the sabotage of Iraq's oil export infrastructure, attacks on oil workers in Saudi Arabia, the uncertainty over the future of the Russian oil company Yukos – which accounts for almost 2% of world production – and threats of supply disruptions in Nigeria and Venezuela. The impact of speculation on oil prices is harder to quantify, but may also account for some of the volatility.

With strong demand and supply tight, even small perturbations to the oil market can induce substantial price movements. In such a volatile market, industry participants have higher desired levels of inventories, and require a larger spot price increase, relative to the forward price, to release stocks to the market. This is the case at the time of writing. Oil industry stocks, having trended downwards over the 1990s, have been low in relation to demand and have reduced the flexibility of supply, but the demand for stocks has built up over the year, putting upward pressure on the oil price.

As uncertainty dissipates, the oil price will fall. However, some influences appear likely to be long-lasting. Over the first half of 2004, strong demand contributed to the strengthening of oil prices. The composition of oil demand in early 2004 reflected stronger than anticipated output growth in dynamic Asian economies, and particularly China. The dynamic Asian economies and China accounted for almost one half of the additional demand, with outturns somewhat higher than industry projections made at the beginning of the year.

Pressures from the demand side are likely to continue, though if high prices persist, the higher long-term price elasticity of demand will lead to lower demand in the future.

Low investment means production capacity is tight. Spare capacity in OPEC countries – principally in Saudi Arabia – has been reduced over the course of the year. As a result, it is estimated that spare capacity in OPEC countries has narrowed to around 1 million barrels per day. (As recently as 2002, OPEC spare capacity exceeded 6 million barrels per day.) At the same time, there has been little spare capacity available outside the OPEC producers to respond to surges in demand.

More recently, in the context of expectations of rising oil prices, investment in exploration and development in non- OPEC countries has picked up relative to activity in the 1990s. But lead times in bringing additional supply to market mean that such investment does little to alleviate pressure in the short run.

In fact, without the increased development of OPEC producers’ substantial reserves, supply is likely to remain tight for some time to come.

While price projections for a volatile market are very uncertain, and near-futures prices are poor predictors of the future spot price, several indicators point to expectations that as the influence of shortterm factors abates, oil prices will be permanently higher. In the first place, far futures prices (six to seven years out) have risen, whereas, throughout the 1990s, prices for the longest available futures remained very stable at around $20 per barrel. Second, oil company analysts have raised their longer-term price expectations by around $5 per barrel since the beginning of the decade. Equity investors' valuations of oil company assets have also apparently risen, in line with expectations of higher oil prices.

Taken together, these factors suggest that, though prices will fall from current levels as the impact of short-term factors dissipates, some elements behind the recent rise will have a longer-lasting impact.

References

See the Special Chapter, “Oil Price Developments: Drivers, Economic Consequences and Policy Responses” in the OECD Economic Outlook No 76, November 2004.

©OECD Observer No 245, November 2004




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