2023-11-09 11:02:29
The price of oil, to date, has only experienced a temporary and fairly moderate increase at this stage. It has fallen sharply since peaking at USD97/barrel in September, trading around USD85/barrel recently following a temporary surge to around USD90/barrel following the Hamas attacks in Israel. However, we can start from the principle that in the future, a risk premium must be included in the oil price even if a lasting surge in this price is only likely in the scenario of a significantly stronger escalation with, for example , a closure of the Strait of Hormuz. In fact, nearly 20% of oil passes through this strait (US Energy Information Administration).
The dynamics of oil supply and demand
Let’s first look at the current context in terms of supply and the risks of a major increase in oil prices. This obviously depends on a possible escalation of the conflict. However, it is important to emphasize that the situation is very different from the oil crisis of the early 1970s following the Yom Kippur War between Israel and certain Arab countries. Oil supply is much more diversified today, which significantly reduces the risk of shortages.
Indeed, the United States has become by far the world’s largest oil producer. Although there is an adjustment period, some key producers in the United States have the ability to increase production in the event of a price spike. It is therefore unlikely that the price of oil will increase substantially and sustainably as in the 1970s.
Also note that in a market economy, a more persistent increase should lead economic agents to look for substitutes and the drop in demand will, all things being equal, induce a drop in prices. The share of renewable energies in gross final energy consumption is already on average 20% in the European Union (Eurostat 2021) and both the high price level and the uncertainty linked to the price of oil should favor a process of substitution. Indeed, alternatives exist even if they are not all competitive at the current price level.
The vulnerability of economies is much lower today
Economic growth is mainly affected through the decline in household purchasing power, the increase in production costs, and uncertainty which tends to increase risk aversion. Most studies, however, show that energy intensity is much lower today than in the early 1970s. A recent IMF study [1] suggests that “the number of barrels needed to produce $1 million of gross domestic product was regarding 3.5 times greater than current levels.”
At the time, oil prices almost tripled between August 1973 and January 1974. The potential for a decline in purchasing power was linked to rising inflation. There is a direct and indirect effect. The direct effect comes from the fact that oil is part of household consumption and therefore of the consumer price index. The indirect effect results from the transmission of increases in companies’ costs in the selling price of goods whose production requires oil or derived products.
The main issue is the duration of the rise in oil prices and the potential for a price-wage spiral. For the reasons cited above, it is unlikely that the price of oil will return to record levels and stay there sustainably. The potential for wage increases and wage-price spirals depends mainly on the stability of inflation expectations and the bargaining power of unions. This power is more reduced today in view of the almost continuous decline in the rate of unionization in many industrialized countries over the last decades.
In addition, central banks have built a solid reputation among economic agents in recent decades and 5-year inflation expectations have remained remarkably stable despite surges in oil prices in 2008 and 2021. The vulnerability of economies today hui therefore seems significantly less strong. ECB economists [2] recently analyzed the sensitivity of the growth potential of the Eurozone economies. This study shows in particular that a key issue is indeed the persistence of the oil shock, but that there is no empirical proof that such a shock has a lasting effect on the growth potential of economies.
[1] Nico Valckx (2022), ‘Lower Oil Reliance Insulates World From 1,970s-Style Crude Shock’, IMF Blog, May 5th.
[2] Julien Le Roux, Bela Szörfi and Marco Weißler (2022) ‘How higher oil prices might affect euro area potential output’, ECB Economic Bulletin, Issue 5/2022.
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