Buttonwood
Another oil shock?
Jun 1st 2004
From The Economist Global Agenda
SourceThe world depends for low oil prices on an unstable country that seems to be falling apart. No wonder they are rising
BUTTONWOOD had been toying with the idea, horribly clichéd though it may be, of starting this column by telling readers how much it now costs to fill up his Fiat Punto. There were, however, a number of problems with such an introduction. The first is that the Punto took a drubbing on the A12 in Suffolk and has been carted off to the great garage in the sky. The second and third problems are a little more macro: sterling is strong and fuel taxes account for a huge proportion of pump prices in Britain, the combined effect of which is to mute the effects on British consumers (and the economy) of a rise in the price of oil. But the main reason is that the terrorist attack in Saudi Arabia at the weekend made the use of the Punto to talk about oil prices as redundant as Giuseppe Morchio, Fiat’s chief executive until he quit on Sunday.
You could argue that the Khobar attack signifies little. The hostage crisis was, after all, short-lived, and the loss of life relatively small—only 22 died, of the hundreds trapped in the residential complex during the stand-off. Indeed, the attack was not notably worse than most previous terrorist acts in the kingdom. Nobody knows for sure that this latest attack was the work of al-Qaeda, though a statement has claimed responsibility on its behalf. And although most of those killed, who included many foreign workers, were involved in the oil industry, Khobar produces, refines and exports no oil at all. The flow of oil from Saudi Arabia, far and away the world’s biggest producer, has been almost uninterrupted throughout the war in the Middle East. Not only has the country vowed to increase production, it is putting pressure on the other members of OPEC, which meets on June 3rd, to do the same—a big reason, presumably, why oil prices jumped only a bit when markets opened on June 1st.
But all this misses the essential truth. For all that rich countries have weaned themselves off oil in recent decades, they are still hugely dependent for their most important commodity on a nasty, unstable regime in a nasty, unstable part of the world. And both the Middle East in general and Saudi Arabia in particular seem to be becoming nastier and more unstable with every week that passes.
It is hard to overestimate the importance of Saudi Arabia to the oil market. At the moment it produces almost 9m barrels a day. Though oil production in Russia has been catching up fast, Saudi Arabia is still the world’s biggest producer. Two other things make Saudi Arabia more important than any other oil producer. The first is that its reserves are much greater: about a quarter of the world’s proven oil reserves. The second is that, partly as a result, Saudi Arabia acts as a sort of central bank to moderate swings in oil prices. It turns on the taps when oil is in short supply and prices rising; and turns them off again when oil is plentiful and prices falling. But so high is demand around the globe at the moment that other members of OPEC are already operating at close to full capacity, if not at it. And no one knows how much more Saudi Arabia can churn out now. Hence the worries about a big terrorist attack on Saudi oil production, and the fears that the attack at Khobar might herald one.
No Arabist, Buttonwood probably knows as much as most about Saudi Arabia, which is to say very little. The country is in some ways the world’s most absolute monarchy, though there are many warring factions within the ruling house of Saud. It has been run by Crown Prince Abdullah, King Fahd’s half-brother, since 1995, because of the king’s ill health. But the prince has been treading a difficult path between the middle classes, who want more reform and liberalisation, and those—not least the fundamentalist Wahhabis, on whom the ruling family still depends for its moral authority—who think that the centre of Islam has become corrupted and westernised.
A measure of disaffection in Saudi Arabia is that three-quarters of the suicide bombers who attacked the twin towers came from the country. Support for al-Qaeda seems to be widespread: terrorist attacks have been increasing. Though the country’s security services have been cracking down on terrorist suspects, they have so far killed only eight from a most-wanted list of 26 published last December, plus a couple of dozen others that did not make the list. On such a country does the world depend to keep crude prices low.
So it should not come as much of a surprise that the markets doubt that it will, which is partly why prices rise with each new setback in the Middle East. Some people dub this the “terror premium”: the extra few dollars on the price of a barrel from the threat of an attack on a big oil-production facility, in Saudi Arabia or elsewhere. It will subside, so the argument goes, when headlines become less gloomy. Others think that such concerns are overdone: prices are so high only because “speculators”, by which they generally mean hedge funds, have been buying in record quantities—how dare they!—on the New York Mercantile Exchange. When they are forced to sell, oil prices will collapse. Both arguments strike Buttonwood as odd, but the second is of arresting awfulness. It makes many dubious assumptions, but the worst is that those selling oil futures (largely producers, the figures suggest) are less likely to cut their opportunity losses from having sold crude too cheaply than hedge funds are to take profits.
It is as likely that with oil prices refusing resolutely to fall, despite the predictions of most pundits, the opposite could be true, sending prices higher still. However, adjusted for inflation, they would have to rise an awful lot to reach anything like the levels reached in the two oil shocks in the 1970s. Many economists also comfort themselves with the thought that rich economies are now far less dependent on oil than they were, and that the underlying reason for the price rise has as much to do with increased demand, especially from China, as with events in the Middle East. That will make the effects on rich countries much less severe than the two 1970s oil shocks, which were caused by OPEC turning off the taps.
A nice argument, except that a demand shock from China looks very much like a supply shock to anyone else, and worries about the Middle East are arguably just as important. Moreover, the situation looks very different in America, where the effects of rising crude prices flow through to the forecourt much more quickly than in Britain because the dollar has been weak and because taxes account for a smaller proportion of the pump price (23%, versus 75% in Britain). A short-lived third oil shock, in 1990 (just ahead of the first Gulf war) was enough to help tip America into recession. America’s gasoline prices have risen 40% or so since December. The effect of this rise is much like a tax, and it will eat into consumers’ wallets at the same time as the government’s huge fiscal stimulus is wearing off. Unless they can put up prices, companies, too, will have to accept lower profits.
In other words, the rise in the cost of crude oil could be inflationary or it could be contractionary or it could be both. And if Saudi Arabia falls apart all bets are off: for the Americans will be damned if they step in and damned if they don’t; the price of crude will rocket; and the world will be talking about a fourth oil shock.