Oil Price Manipulation
By Stephen Lewis
Of Monument Securities
LONDON (Dow Jones)--This week's surge in global long-term yields, which partly reversed yesterday following a successful US 30-year Treasury bond auction, has raised worries that higher borrowing costs will strangle hopes of economic recovery.
US mortgage rates are substantially higher than they were a month ago. In due course, the impact of dearer mortgage loans will be seen in US housing and consumption data.
Some observers are beginning to wonder whether this year's rise in oil prices might not have a similar effect in damaging chances of economic revival.
Since December, near-term crude prices have more than doubled, from below $35/bl to above $70/bl currently. Previous instances when crude prices have shown similar proportionate gains have earned the label 'oil shocks'. They have had measurable effects in subtracting from world economic growth, as in 1974-75 and 1980-81.
There is a prima facie case, then, for seeing this year's 'oil shock' as killing the chances of an upturn in global business activity. However, we should guard against taking too superficial a view of these oil price effects.
Though the oil price has staged a spectacular rally over the past five months, oil is still not expensive by recent standards. So far this year, the average price of the OPEC basket of crudes has been $48.86/bl. That is roughly one-half the 2008 average of $94.45/bl. It is also lower than the annual averages in every year since 2004.
Since consumers of oil typically spread their oil purchases over time and some have recourse to forward markets to secure supplies, short-term movements in spot prices are not reliable indicators of the economic impact of oil market behaviour. Longer-term averages of oil prices offer a better guide to the oil costs that consumers face. On that basis, there is still a strong case to argue that the effect of oil prices on general economic activity in consuming countries will be supportive this year.
If oil prices follow a trajectory in line with widely-publicised forecasts that see them reaching $85/bl by the end of this year, the 2009 average price will be 33% below 2008's average. This is the equivalent of a 1.5% boost to the real incomes of oil consumers.
Admittedly, if the oil price had stayed around $30/bl, the boost to real incomes this year would have been even larger, at some 3.0%. Further, cheaper oil is likely to serve as no more than a stabiliser of economic demand in consuming countries, which are suffering larger-scale adverse shocks as a result of de-leveraging and past misallocations of capital.
If the oil price were to stay at $85/bl throughout next year, moreover, it would seriously crimp growth in consumers' real incomes in 2010 (perhaps subtracting 1.0 percentage point or so from their rate of expansion), and limit prospects for sustained economic recovery.
However, even if oil prices had remained in the $30-35/bl range this year, the chances would have been that a pick-up in demand would have sent it higher next year, with negative implications then for consumers' real incomes. Unless the global economy takes a further lurch downwards in the months ahead, it seems unavoidable that oil prices will act as a brake on demand in the consuming countries in 2010.
We should reflect, however, that the interaction between oil prices and global demand is more complex than it was thirty years ago.
Lower oil prices this year have helped to support households' real incomes in the consuming countries and have contributed to the resilience of these households' spending. But, at the same time, they have cut into the incomes of oil producing countries, leading to cutbacks in their outlays.
This matters more than it did in the 1970s because oil producers, in general, now have a higher propensity to spend their receipts from oil exports. Whereas, in earlier decades, the oil producers tended to channel their oil earnings into financial assets, recently they have been prompt in bringing forward capital spending projects to absorb surplus revenues.
Consequently, when the collapse in oil prices in the second half of last year depleted their revenues, the oil producers moved swiftly to scale back their spending on imported capital goods. This has been reflected in the extremely steep declines in capital goods exports of the developed countries. The process seems set to go into reverse over the next year, to the benefit of capital goods producers, if the oil price does no worse than hold around current levels.
The IEA yesterday raised its projection of world oil demand this year from 83.2mbpd to 83.3mbpd, though that is still 2.5mbpd down on 2008. The IEA judged OECD industry inventories at end-April to have given 62.0 days' forward demand cover, 7.5 days more than in the same month in 2008.
It is by no means certain, then, that end-user demand will support market forecasts of sustained strength in oil prices. This year's rise in oil prices is more plausibly explained as a liquidity-fuelled advance, on the back of central bank asset purchases.
As long as central banks continue to pump in liquidity, oil prices should stay firm. But as soon as their asset purchases cease, there will be a serious risk of oil prices breaking down.
Similar considerations apply more widely to commodities prices. Though Chinese demand is widely cited as sufficient reason for the cost of raw materials to have risen over the past few months, Chinese data give grounds for doubting whether this factor will be sufficient to underpin commodity markets. The sales/output ratio for China's manufacturing industries fell from 97.8 in April to 97.3 in May. Not only is output running ahead of sales, it is doing so by an ever-widening margin.
As an illustration of the consequences, annual growth in ferrous metals output in China picked up to 2.3% in May from a negative 6.3% last November. Producer prices for steel, however, dropped by 28.1% in the year to May.
China's National Statistics Office noted earlier this week that an over-supply of industrial goods could prevent producer prices from rebounding. The implication is that if raw material prices continue to rise, Chinese producers' margins will be severely squeezed. This is likely to lead to cutbacks in output.
-By Stephen Lewis: (+44) 20 7190 7193; email@example.com
(Stephen Lewis is chief economist at Monument Securities Ltd., London, independent brokers specializing in institutional business.)