Bubbling Up

The prospect of war in Iraq and a cold northern winter have helped push oil prices up to their highest level in a decade. How much damage could expensive oil inflict on the world economy?

IT WAS over almost faster than you could fill your car with petrol. But the sudden surge in American oil prices on February 27th showed just how nervous the oil markets are—and just how elusive oil-price stability is at present. The price of the benchmark American crude shot up by more than $2, coming within a whisker of $40 a barrel and hitting a level not seen since 1990. It quickly subsided, but remains not far off double the price of a year ago. Sustained higher oil prices would inevitably spell trouble for the world economy.

That is trouble it doesn’t need: economists are already fretting about the weak performance of most of the big industrial countries. Political uncertainty and structural problems have hindered growth prospects this year. An oil-price shock would at best slow recovery and at worst send the global economy back into recession.

Whether the current high level of oil prices, constitutes a big economic shock is unclear though. Indeed, it is not wholly clear why prices are quite so high. Uncertainty about war with Iraq is a factor: oil traders are worried that military intervention would interrupt the supply of oil from Iraq, currently running at around 2m barrels a day. They also wonder whether a prolonged conflict would affect supplies from other Middle Eastern oil producers, either because of physical damage to oilfields or because of some sort of political embargo on oil supplies. The Malaysian prime minister has already floated the idea of Muslim countries imposing such an embargo on Western consumers.

But Iraq doesn’t wholly explain the recent spike in prices. Three other factors are also in play. One is the coldest winter in the northern hemisphere for many years. Demand for oil, always higher during the northern winter, has risen sharply. Another factor is the big drop in American oil stocks, now at their lowest level for years. Even the Bush administration’s declared readiness to release some of America’s massive contingency reserve of oil has failed to calm fears about the impact war might have on already tight supply.

The third factor keeping the oil market tight is supply constraints outside the Middle East. The lengthy strike in Venezuela had a big impact, especially in America, its main customer. Although the strike has finally ended, experts reckon it could be months before Venezuelan exports are back to pre-strike levels. And traders are now getting rattled about possible interruptions to supplies from Nigeria if there is trouble there in the run-up to the presidential election in April.

Those with long memories—and an inclination to fear the worst—keep recalling the oil-price shock of 1973-74 when, in the aftermath of the Arab-Israeli war, the Organisation of Petroleum Exporting Countries (OPEC) used its muscle to quadruple prices within a very short space of time. This stopped the world economy dead in its tracks and gave economists a new phenomenon to worry about: stagflation (no economic growth combined with high inflation).

All the economic evidence shows that sustained oil-price rises have a big negative impact on economic growth: similar effects were seen after the next big price hike in 1978-80. More recently, the pick-up in prices in the late 1990s helped end the long boom which, in America and parts of Europe and Asia, then turned into recession. The fact that recovery since then has been so tentative explains why the recent surge in prices has alarmed some economists.

Against that, though, is the prospect of a sharp fall in oil prices if a war in Iraq were to be short and successful, without collateral damage to oilfields in Iraq itself or surrounding countries. With winter ending, emergency reserves set to be released in America and Europe and the prospect of much higher exports from Iraq eventually, it is not difficult to paint a much rosier picture.

Indeed, there are signs that some members of OPEC are beginning to reflect on the damage that might be inflicted on the cartel if the price fell too much after a war. In a newspaper interview, the Saudi oil minister, Ali Naimi, spoke of OPEC’s role in providing stability for the oil market. He acknowledged that prices were currently not in the fair range and that he would like to see them lower. But he warned that ending OPEC’s influence would lead to a damaging free-for-all: for many producers, lifting oil out of the ground ceases to make sense when the price is low.

Mr Naimi was eager to reassure the markets that, if necessary, Saudi Arabia could raise production to compensate for the loss of exports from Iraq. He argued that producers need oil revenues just as much as consumers need security of supply. He did not add, but could have, that OPEC now accounts for a significantly smaller share of world oil output than it did in the 1970s; it is thus much less able to determine prices than it used to be.

Because it is so difficult to predict the outcome of military intervention in Iraq, nothing is likely to ease the oil market’s nervousness in the short run, though. The oil price is likely to remain high and volatile. And world economic recovery is unlikely to gather pace until the atmosphere of uncertainty lifts.