What is the real impact of the Price of Oil?

Following a series of geopolitical revolutionary events that spread across North Africa and the Middle East, the oil price witnessed a record high when it reached $120 a barrel in February, after disruptions in the oil pipe lines fuelled concern about supply. Nonetheless, the price of oil is now slowly finding its way back down, as fears that world economy is stalling have reduced demand for commodities. In addition, foreign exchange markets are also putting a strain on oil prices which are in US dollars. The dollar is strengthening against the euro and so oil prices are easing.

Supply worries

Another element that is driving oil prices higher is natural supply. Oil fields have an annual decline of between 5% and 8%. Experts claim that it is going to be at least 10 years before we see any production emerging from large projects like Exxon and OAO Rosneft's Arctic exploration. Subsequently, the oil industry is expected to see a resumption of merger and acquisition activity is such environment.

Emerging market growth

However, as the world population keeps continuously growing and as the emerging market economies are posting record growth and thus fuelling demand for oil, what will happen if the oil price rises again?

Emerging markets have long captured investors' attention, as they recognised that such growing economies can offer some of the fastest growth and in turn profitable investment opportunities. Along with China, Brazil and India has received significant attention, and for good reason.

In 2011 alone, the Gross Domestic Product (GDP) in India expanded by 7.7% in the second quarter, China is forecast to post 9.5% yearly growth and Brazil is expected to grow within the average of 4%. The rapidly growing population of these economies are thus now demanding a higher standard of living. Consequently, China and India now reportedly account for the largest share of growth in the consumption of commodities and energy and such growth is likely to continue in the years ahead.

Consequently, higher oil prices are naturally likely to take a toll on potential growth, due to higher input costs and the detrimental effect of increased price volatility on business sentiment. This is particularly worrying when seen in the light of the fact that the US and the euro-zone have found themselves in fiscal trouble over their debt, leaving a narrow path for economic growth. US consumers are thus cutting back on fuel consumption because of the high prices. In fact, data shows that US consumption of distillate fuel slumped by 5.2% in September.

Could such emerging-market growth therefore make it more difficult for the US and Europe to recover, if the oil price continues to increase?

According to the OECD 2011 report, The Effects of Oil Price Hikes on Economic Activity and Inflation, a $10 increase in the price of oil could reduce economic activity by two tenths of a percentage point and raise inflation by roughly two tenths of a percentage point in the first year and another one tenth in the second year. This therefore implies to a fall in household real incomes as goods become more expensive with inflation, yet the average household income remains the same.

The inflationary impact of oil price hikes also depends on the ability of authorities to prevent inflation expectations by drifting away from targets, the report states, as they set out multiple sentiment signals in the markets.

In addition to the report, according to the IMF analysis, Oil Shocks in a Global Perspective: Are they Really that Bad?, economists Tobias N. Rasmussen and Agustin Roitman argue that although oil prices have "a negative effect on oil-importing countries", the impact is not as large as they had previously thought. They claim that, for instance, a 25% increase in oil prices will cause a less than 1% loss of GDP in oil-importing countries, spread over 2-3 years.

Interestingly, they point out that an explanation for this low impact is the fact that a part of the greater revenue that oil exports are accruing will be recycled in the form of imports, thus boosting international trade with oil-importing economies.

Another important aspect to factor in is the fact that as the price of oil balloons, so is the Middle East economic growth. In 2011, the region that is best known for producing and exporting oil, is expected to average a real collective GDP growth of 4%, as its revenues from producing and exporting oil continue to bloom. The Middle East is now in the midst of an oil boom and oil producers are increasingly turning the oil wealth into longer-term revenue streams.

The Track Record

Crude oil prices behave like any other commodity, with wide price swings in times of shortage or oversupply. The crude oil price cycle directly responds to changes in demand as well as OPEC and non-OPEC supply, as we can see below.

A low point was reached in January 1999, when oil was priced at $17 per barrel, after increased oil production from Iraq coincided with the Asian Financial Crisis which reduced demand.

Prices then increased rapidly, doubling by September 2000 to $35. It fell again later until the end of 2001, before steadily increasing, reaching $40–50 a barrel by September 2004. A month later, light crude futures contracts on the NYMEX for November delivery exceeded $53 and for December delivery exceeded $55.

Crude oil prices then surged to a record high above $60 in June 2005, sustaining a rally built on strong demand for gasoline and diesel, amid concerns about refiners' ability to keep up with the demand. Crude oil futures peaked at a close of over $77 in July 2006.

By September 2007, US crude crossed $80. Multiple factors caused this high price: OPEC announced an output increase lower than expected and the US stocks fell lower than experts had predicted. In addition, there were changes in federal oil policies and six pipelines were attacked by a leftist group in Mexico. In October 2007 US light crude rose above $90 for the first time, due to a combination of tensions in eastern Turkey and the reducing strength of the US dollar.

Oil then broke through $110 on March 12, 2008 and soared to $147.27 on July 3, following concerns over recent Iranian missile tests. On July 14, 2008, US President George W. Bush lifted the executive order to remove the ban on offshore drilling that had been enacted since 1990. Consequently, oil then dropped below $100 for the first time in seven months. Remarkably, on December 21, 2008, oil was trading at $33.87 a barrel, less than one fourth of the peak price reached four months earlier.

Prices did not rebound once 2009 started, oil descended by mid-February to below $34, hurt by forecasts for further declines in world demand. However, by August 2009, prices returned to $70 a barrel.

Crude oil price rose by nearly 13.8% from January to December of 2010, when it topped $80 per barrel.

In 2011, the price of Brent crude jumped by 15% as geo-political instability in North Africa and the Middle East, the largest producing regions in the world, threatened supply. Oil reached $120 a barrel on February 24th.