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Oil Prices and the World Economy

By Andrew McKillop

The Current Situation

The facts are overwhelming. Oil prices described as ‘very high’ by many commentators have most certainly not damaged or ‘cratered’ the world economy. In fact the world economy and oil prices have grown together, almost step by step since the most recent oil price low, in early 1999. Today, it is incredible to think that contracts for crude changed hands at 10 USD/barrel in 1999, but this was the case. Since then, and using nominal dollars (unadjusted for inflation), prices have grown about 575%.

Claims are made that there are ‘delays’ among economic agents and economic deciders, hampering or slowing down ‘price-elastic adjustment’ of demand – that is a fall in oil demand due to high prices. If this was the case, however, falls in demand will or should mostly concern final consumers more than intermediate agents, like industrialists and manufacturers. This is because intermediate energy users often depend on energy-intensive and oil-intensive raw materials, and also all of them use process energy, to produce goods.

Now it is said that intermediate users, at least in theory, tend to ‘pass on’ the energy price rises they suffer, often ‘anticipating’ inflation by increasing their final prices more than strictly justified by their raised energy costs. If this was the exact case, this would further penalize final users, causing faster or further economic downturn. The service sector, which is supposedly ‘energy-lean’ and therefore less affected by energy price rises, is seen as a kind of ‘bulwark’ against high oil and energy prices, explaining the attraction of the ‘decoupling’ or ‘de-materialization’ myth in New Economy theory. The service sector, in theory, should not be affected, in direct terms, by high oil prices. In fact we find the service sector needs much energy, because of economic infrastructures like telecommunications needed to support service sector.

Overall, therefore, we must look for signs of downturn in the entire global economy if we want to argue that “high oil prices damage the economy”.

At present, we do not have major signs or ‘signals’ of high oil and high energy prices adversely affecting the world economy. In fact we find many signs of rising energy prices faster driving the world economy, and we badly need to explain and understand these signals to find the areas and sectors for best, most productive investment and development.

Energy and Development in Time of Rising Oil Prices

It is well known that economic development needs large quantities of energy of all kinds: oil, gas, electricity, coal. Due to global markets and energy trading, there are today smaller differences in prices between these fuels. This restricts choice to technical criteria and factors, including type and kind of equipment and machinery that is selected, purchased, installed and operated. Increasingly, also, there is demand for multi-fuel or flexible equipment and machinery that is able to run on more than one primary energy source or fuel source, with minimum ‘down time’ and minimum cost for switchover.

Anywhere in the world, and in any historical period, economic growth of countries depended on those countries using more energy. If we study the history of fast economic growth in Asian Tiger economies, and focus their period of fastest growth and development, that was approximately 1975-1990, we find that Asian Tiger economies experienced very fast growth of oil demand at exactly the time of most-recent fastest increase of oil prices, that is in 1973-1974, and again at time of highest real price of oil, that is 1979-1981.

Please see table, below:

Asian Tiger economic demand-driven, close-coupled adjustment to Oil Shock*

Oil Consumption Thousand barrels/day


Source: BP Statistical Review of World Energy, 2002, 2003

The reason for this ‘surprising’ behaviour – that is increase of oil demand when oil prices rise – is due to macroeconomic mechanism where higher revenues completely displace any ‘price elastic’ impact from much higher oil prices. In other words, more revenues from increased exports of industrial and manufactured goods more than compensates problem of higher priced oil imports. This is called ‘close-coupled’. Today we have exactly the same mechanism working with China and India, and many other countries. The net result is to: quickly lever up world economy growth rate. This in turn quickly increases oil demand.

We can easily develop this analysis of positive feedback mechanism with complicated charts and diagrams, such as ‘price elasticity curves’ but it is better to explain the global economy mechanism of adjustment to oil price rises.

The simplest description is of revenue changes. The increase of oil and energy prices also causes big increase of all raw material commodity prices. We can take almost any example, for example copper, cotton, coffee, iron and steel, sugar and many others. In all these cases there has been price increase of at least 200%, sometimes 300% or more, since 1999.

It is therefore no good for IMF, World Bank to claim, as they do, that high oil prices will cause economic recession and especially damage economies in developing low-income South. What we are seeing is accelerating and increasing growth in several regions, including Africa, which for many years suffered very serious economic difficulties and much human suffering, in the 1980s and 1990s when oil was very cheap.

Recent estimates (April 4, 2006) by the IMF and World Bank of economic growth for main world regions are as follows (growth on real GDP basis for each country in region):

See table below

Detailed Analysis Method

When expert at the European Commission DG XVII-Energy, and as research worker for OAPEC (papers published in Oil & Arab Cooperation Quarterly*) I have many times proposed the approach of:

Oil Coefficient analysis for economic and energy planning

This again is simple approach but can give very detailed and useful results, if properly developed and applied. Oil coefficient, and energy coefficient, and electricity coefficient means the change of oil, energy or electricity demand with 1% change of economic output or economic growth. Whole economy can be studied, and different economy sectors inside the whole economy can be studied. By making studies of coefficient performance over time and between sectors you have a powerful planning tool for optimizing energy use in economy and selecting the best performance economic sectors in energy terms. If or when there is physical shortage of oil or gas, or electricity shortage, this approach can select best allocation system for rationing.

At this moment in time, before GoI-Government of India there is study proposal by myself, prof. Jaswant Krishnayya, and Maj-Gen Sudhir Jatar concerning oil and energy coefficient study of India’s economy, for long-range planning of oil issue.

Applying this method to world economy and world oil demand, we arrive at concept of oil coefficient per capita or quantity of oil consumed, on average, by each person on world basis. First of all, the world average number is very general, and hides very big differences between OECD countries, and low-income countries. Please see Table below.

Average per capita demand rate, oil demand, 2004

Data Sources for above Table / Population data UN Population Information Network,
Oil demand BP Amoco Statistical Review of World Energy, 2004

This, as I said, is whole world average number, which today in 2006 is now about 4.75 barrels per capita per year. By ‘latent demand’ I mean the probable minimum possible increase of world oil demand each year, if there is zero economic growth and if there is no technology change. At present, world oil demand is increasing with economic growth at a coefficient of above 0.5, that is in 2006 world economic growth will likely cause world oil demand to increase by about 0.55 x 4.9 or close to 2.5% (about 2.1 Mbd).

The very big problem for world oil supply in near future is very clear from the above numbers. World maximum oil production capacity is probably not above 90 Mbd unless price goes very much higher, making possible GTL (gas-liquid conversion) and tarsand oil development (Canada and Venezuela). The real solution is for USA to cut oil demand, and for Europe, Japan, South Korea to reduce oil demand.

Oil Coefficient and Economic Growth

As I said, we can make oil intensity and oil coefficient analysis of all economic sectors, the global economy, and individual countries. We obtain very different results in function to only a few variables. These major variables are:

• Electrification (percent of electricity in total commercial energy)
• GNP per capita in PPP terms (purchasing power parity)
• Economic growth rate of country (also: change of growth rate)
• Economic structure of country (transport; habitat; industry-service sector ratio)
• Urbanization (percent population urbanized)
• Geographical size and climate of country

Examining some of these we find that very fast growth of electrification, fast economic growth, and fast urbanization, especially in big countries, will lead to those countries having a high oil coefficient that is a high growth of oil demand for 1% growth of national economy To give example, with high oil coefficient of 0.7 – 0.8, if the country has economic growth rate of 5%-per-year its oil demand will increase by 3.5% to 4%-per-year.

The reasons why electrification increases oil coefficient are quite complicated, but we can explain the economy as made up by 2 components, the ‘core’ economy and the ‘shell’ economy outside core. Inside the ‘core’ economy there is large electrification, with much use of electricity replacing direct use of oil or gas. At the ‘shell’ or outside the electrified core, there is little development of electricity and these new regions and new economic sectors, such as processing of agriculture products and light manufacturing grow very fast. This is mainly oil-based and gas-based. In turn, this drives the ‘core’, making it also grow but only after some delay. New growth inside the ‘core’ will then also be mainly oil-based and gas-based, resulting in higher oil coefficient and higher oil demand by more than growth of economy. In other words, the whole economy can have eg. 1.1% oil demand growth for 1% economic growth, or 6.6% oil demand growth for 6% real GDP growth. This can be for quite long periods. It can be 6 months, it can be over 1 year, or more.

As I said, this is a complicated subject, but is related to the performance of the economy in energy terms when there are different rates of economic growth. For example, when an economy suddenly starts to grow very fast, after a period of slow growth, it will have rapid increase of its oil coefficient of economic growth. This can be a surprise to planners, but the reasons are easy to explain and to analyze.

We could give example, able to be proven with simple data, for many different countries at different times. Where a country goes from 3%-per-year economic growth to 6%-per-year economic growth, its oil coefficient can jump from perhaps only 0.45 to more than 0.7, and its oil consumption will increase much faster than planned, forecast and budgeted. Where there is also big programme of electrification, the growth in oil demand of the country will be even faster. Slowing down is just the same but in reverse: oil demand of the country will fall faster than expected except in economic sectors and regions where electrification is strong.

Summing up here, we can say that electrification slows down the process of economic growth when increasing, and slows down the decrease of economic growth when it is decreasing. It acts like “engine braking” in cars and trucks. It also tends to slow down economic growth and reduce oil coefficient where economy is fully-developed or ‘mature’, and has experienced big development of service sector. But it also reduces potential for economic growth, while also increasing the country’s oil coefficient when economic growth becomes fast. If the electric power system is mostly thermal, that is oil-fired and gas-fired, the oil coefficient will be close coupled with economic growth, as well as tending to slow down economic growth. There is therefore a disadvantage in going too fast with electric power construction and development.

Oil Intensity and the Oil Price

Of course the subject of oil price forecasting is supposed to be very complicated and not at all connected with rational data and factors that can be easily analyzed. Many so-called “experts” study the OPEC communiqués and statements by oil ministers, and then get paid to imagine and guess if this means higher or lower oil price. Most of these “experts” know nothing at all about oil or energy, and so they are usually wrong.

When we take long-term data, and we use the single factor of oil intensity which as I explained above is the oil coefficient of world economy, we find that world oil price changes since 1965 and to 2005 are rather easy to interpret, and future trends quite easy to forecast.

First we show numbers for world oil demand and world per capita intensity. We then use these to compare oil price changes with per capita oil intensity changes through the long period. Until 1983-1987, when there was very big increase of daily NYMEX and other oil trading, and much more variation in daily price, there was abandonment of the single contract direct trading system operated by major oil exporter entities (National Oil Companies and their agents), and by major oil importer entities (often state purchasing companies and National Oil Companies). These, before 1983-1987, used many different purchasing methods and payment methods.
Thus calculation of average prices for that period was more difficult. The tables below use Year Peak oil prices corrected for inflation, in US dollars . This can be criticized as needing PPP correction to further improve analysis.

Please see 2 tables below.

Table World per capita average oil demand and oil price trends 1965-2005*

CONCLUSIONS

This brief look at major impacts of oil prices on world economy, and determinants of oil demand and growth rate changes of oil demand inside the economy, brings up many questions concerning the best management and planning of the energy economy. That is the economic infrastructures using energy, and producing energy. Fast electrification is not the very best strategy, and needs careful planning.

Regarding the current oil price trend, and world economic growth it is important to note that interest rates in OECD will have much more powerful impact on economic growth outlook than oil prices up to perhaps 90 USD/barrel. Before 90 USD/barrel, only interest rate hikes in USA, Europe, Japan can quickly decrease economic growth and increase inflation.

The argument that high oil prices decrease economic growth is not true. Only very high oil prices can affect economy, and then only when intermediate agents in the economy, that is industrial and manufacturing producers, put up their output prices by more than justified (that is by more than oil and energy price rises they have to bear). This question concerns not only energy policy, but also fiscal and tax policy of country.

Conversely, if the monetary deciders in OECD, that is the US Federal Reserve, the European Central Bank, and Bank of Japan increase interest rates fast, and by marge amounts, this can cause world economic recession by reducing export markets for nonOECD countries.

The main reason for this is that there is near total absence of real, efficient, convenient or cheap alternatives to oil and gas. This explains why economic agents, that is everybody, goes on using them. It will soon be vital to make energy transition away from oil and gas because will soon start to fall, if only slowly at first. This will require much effort and much investment in energy conservation, sustainable technology, and renewable energy sources.

The narrow question of why oil demand, and gas demand, are growing very fast compared to 1990s, when oil and gas prices were much, much lower than today is answered by the fast ecoomic growth of today. Further analysis shows that oil intensity and oil coefficients decide how fast a country’s oil and gas demand will increase, also depending on other energy economic variable and factors.

Narrow economic study of so-called ‘price elasticity curves’ will not be useful for oil and gas energy economic analysis and forecasting. The economics definition of price-elasticity includes the two ideas of ‘satisfaction’, and of ‘substitution’. Neither of these have much place for the vast majority of oil and gas users. Nobody uses oil and gas ‘for the fun of it’, or ‘to get satisfaction’ that is pleasure simply from using them. At present there are no easy and cheap substitutes for oil and gas. So the questions of ‘satisfaction’ and ‘substitution’ do not come into the equation in any real sense.

Future planning and development of the energy system or energy economy must include increasing potential for flexible, multi-fuel equipment, for more widespread development of different and smaller energy resources, as well as conservation and the renewable sources.

In the short-term of 9 months, and unless there is either 100-dollar oil, or OECD raises interest rates very quickly and by large amount, it is unlikely there will be economic recession.

*References:

Articles by Andrew McKillop published in ‘Oil & Arab Cooperation Quarterly’,
OAPEC, Kuwait (eg. Issues 51, 54, 55 1988-1990)

‘Oil Crisis and economic Adjustment’, Andrew McKillop and Salah al-Shaikhly,
Pinter Press, ISBN 032583208

‘The Final Energy Crisis’, General Editor Andrew McKillop,
Pluto Books, ISBN 0745320929

 

Andrew McKillop is a Founder member, Asian Chapter, Internatl Assocn of Energy Economists and Former Expert-Policy and programming, Divn A-Policy, DGXVII-Energy, European Commission. Author of several books on energy, environment and development published in UK, Canada and USA.( xtran9@gmail.com ) His latest book ‘The Final Energy Crisis’ (ISBN 0745320929) is distribute by Pluto Press, London and will be on sell shortly by Petroleumworld (pwbookstore@ hotmail.com). Also, Petroleumworld is negotiating the rights for the Spanish edition. Its views are not necessarily those of PETROLEUMWORLD.

Editor's Note: This article summarizes Andrew McKillop speech at the POGEE - Pakistan Oil, Gas & Energy Conference 2006. Petroleumworld reprint this article in the interest of our readers.

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Petroleumworld News 07/02/06

Copyright©2006 Andrew McKillop. All rights reserved

 

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