The Oil Shock With No Pain

The inevitable never happens, the unexpected always does. Economists long believed a good rule for the global economy was that every time the price of oil doubled or exceeded $35 a barrel, the world would enter a recessionary phase. Even today, news coverage continues to project the image of a world besieged by higher oil prices, and economists think a major global economic slowdown is inevitable. Instead, one of the biggest surprises of this decade is that a 200 percent surge in crude prices hasn't hurt the global economy.

Even as spending on petroleum as a percentage of the world's gross domestic product has risen to 4.5 percent--levels last seen during the 1979-80 oil crisis--the global economy continues to expand at a more than decent clip of 4.5 percent. To be sure, there's greater recognition of the fact that, unlike the past, when oil-price surges were driven by supply shocks, the current rally in oil is mainly the result of a demand shock. The jump in oil prices is triggered by a very strong global economy, with increased contribution to growth coming from emerging markets, which tend to demand more oil than developed peers for a similar expansion in output.

The "demand-led" nature of the shock implies incomes in countries such as China and India are rising along with oil prices. That works to neutralize the traditional negative impact of higher crude prices. But the underappreciated story of the ongoing episode is how oil-producing countries are better using their revenue from exports of the commodity. Theoretically, an increase in the price of oil represents a transfer of wealth from oil-consuming countries to oil-producing nations. In the past this was a big net negative for the global economy as oil-producing countries were inefficient users of capital, and oil money lined a few select pockets rather than contributing to economic activity in those countries.

This time around, the crude-producing nations have done a much better job of recycling oil money into the global economy. The trade-balance numbers of the Organization of Petroleum Exporting Countries, or OPEC, as well as those of Europe and some emerging markets, support that notion. The OPEC countries, for instance, are running only a slight trade surplus with China--where they are buying a lot of low-cost goods. At the same time, China is using more oil to manufacture those goods for export.

The economics team at UBS estimates that OPEC is now consuming 83 percent of its export revenues from oil, compared with 1974, when it was spending only 27 percent of its petrodollars. The much higher propensity of the OPEC members to consume is one of the most important reasons behind the resilience of the global economy in the face of a mega bull market in oil.

Oil-producing countries have also been more active in the international investment arena, using their windfall revenue to buy stocks and bonds in various countries, thereby keeping the global cost of capital low. That phenomenon is reflected in record-low bond yields and is an important factor in financing sizable current-account deficits in large oil-consuming countries, such as the United States.

Still, demand has held up well for many reasons, not all positive. There are distortions in the pricing mechanism, which are cushioning the impact of higher crude prices. Normally, higher prices should eventually slow demand as part of a self-regulating market process. This time, based on a worldwide average, only a third of the price increase has been passed on to end-users even as oil prices have doubled over the past three years. In fact, the United States is probably the only country where the rise in energy costs has been matched by an increase in end-user prices. In Europe and Japan, the very high flat taxes on oil consumption mean the rise in oil prices only has limited impact on the overall retail price, and in many developing countries, governments are subsidizing oil prices outright.

We are now beginning to see responses from various market participants that should make the present run in oil prices self-correcting and, it is hoped, prevent it from reaching a boiling point. Governments are increasingly forced to pass on global oil-price rises, while spending by oil companies on exploration is picking up as the realization sinks in that the current price cycle is more than just another boom-bust one. Anecdotally, consumers are starting to respond to the high prices of crude, with sales of SUVs in the United States plummeting, sales of hybrids and bicycles increasing worldwide and the customer base for premium gasoline at fuel pumps drying up.

The world can live with higher oil prices if it listens to market signals: oil companies need to invest more in exploration and emerging markets need to allow more realistic retail prices. While all that may be in the works, be careful what you wish for. Yes, the old link between high prices and slow growth appears to be broken. But it has been inverted in a way that is almost as worrisome: the surest way oil prices will fall significantly is if global economic growth slows dramatically.