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Issue 11/17 June 2009

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Today’s Issue Includes:

1) Could the oil price surge stall the recovery? By Nigel Tree

nigelcropforezineWhat’s happening to the price of oil?
Oil prices last year reached a high of $150 a barrel, but as a result of the global recession demand has fallen, followed by prices. In fact by February this year prices had fallen to $32.70 a barrel, but have since risen to reach over $72 a barrel at the end of last week. Why has the oil price recovered so swiftly?

To answer this we need to see what has been happening on both the demand and supply sides.

Demand for oil
Global oil consumption fell by 0.6% in 2008 which was a drop of 420,000 barrels a day according to BP. This was the first fall in demand since 1993 and the biggest drop since 1982. There was a general correlation between the countries most hit by the recession and those who have experienced the biggest fall in demand for oil. For example, US oil consumption fell by 6.4% last year, which had a major impact as the US consumes nearly a quarter of the world’s oil. On the other hand, there were increases in demand in China, India, Africa and the Middle East.

Only last week, the International Energy Agency (IEA) noticed an abrupt change in demand for oil saying that we were seeing the “long-awaited emergence of improving fundamentals.” The IEA forecast that global oil consumption would actually be 120,000 barrels a day (b/d) higher this year than originally forecast, but demand would still drop in total by 2.5m b/d.

Supply of oil
The twelve members of The Organisation of the Petroleum Exporting Countries (OPEC) control about two-thirds of the world’s total oil reserves and accounted for one-third of total oil supply in April 2009. Their actions as a cartel to alter supply give them considerable ability to influence world prices. The graphic below produced by OPEC shows on the bar chart which is calibrated in million b/d how they have steadily reduced supply over the past year in order to respond to lower levels of demand and prevent prices falling even further. It can also be seen that they actually increased oil supply slightly in April. The red line which measures millions of barrels, shows the OECD commercial crude stocks as a difference to a 5 years average figure. This reveals a strong increase in stocks up until January this year. In fact OECD commercial crude oil inventories are now operating close to operational capacity and the fall from the five year average since the beginning of this year shows that inventories appear to have peaked.

So, given that OPEC has been reducing supply, demand has continued to fall and stocks are being run down below a five year average, none of this necessarily explains why prices are rising. So what has been happening to push prices up?

opecoilsupplyjuneWhy have oil prices risen and what is the significance of that rise?
The IEA has warned recently that the price rally has been driven by optimism about a global recovery rather than by “solid demand and supply fundamentals”. OPEC has also pointed out this recent “divergence between oil market fundamentals and prices” saying that crude oil prices have shown a strong correlation with developments in equity markets as well as fluctuations in the US dollar.

It is this concern that oil prices will continue to rise as the recovery takes place, which has driven demand, not for current consumption, but to be put into storage. In fact US crude oil stocks have shown a positive correlation with prices this year, as both stocks and prices have risen in unison.

Also, investors are betting on further price rises. Forward contracts for delivery in December 2017 climbed above $90 a barrel last week. This has given rise to a contango market structure which reflects an upward sloping yield curve in the futures market. This means that the price for future delivery is higher than the spot price.

worldoil_thnAs a result there are strong concerns that a rising oil price may cause a premature halt to any sign of global economic recovery. In fact, just last week, the UK chancellor, Alistair Darling emphasised this by saying: “Oil, in particular, has the potential to be a huge problem as far as the recovery is concerned. We’ve got to convince everyone, including some of the Gulf states, who really have been badly affected by this downturn in their broader economies, it is in no one’s interest that we allow a high oil price to impede recovery.”

It can appear that movements in the oil price are like a zero-sum game, with price rises hitting both advanced western countries and developing countries but benefiting the oil producers. However, last week, BP’s chief executive, Tony Hayward, pointed out that most OPEC countries needed an oil price above the $60-$70 level so that they could maintain their domestic social development programmes as well as invest in future productive capacity. On the other hand, he also pointed out that prices of more than $100 a barrel tend to have a significant effect in choking off demand, and suggested that the equilibrium price of oil is somewhere between the two.

So, it may be that prices have further to rise, but the suggestion is that an equilibrium price somewhere between $60 and $90 a barrel might be the right level to reward the producers without destroying a potential world recovery.

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2) Must fiscal stimulus policies put a burden on the future? by Max Corden, Emeritus Professor of International Economics of Johns Hopkins University, and Professorial Fellow in the Department of Economics of the University of Melbourne.

maxcordenConservative critics of fiscal stimulus policies usually criticise such policies because of the public debt burden they create. It is indeed true that a burden on future taxpayers is imposed if budget deficits that result from stimulus policies are financed by borrowing on the market. But that is by no means the whole story. Rigorous analysis is needed.

On the basis of Keynesian principles stimulus policies are needed when monetary policy cannot, for various reasons, eliminate high unemployment that has led, or is expected to lead, to actual output being below potential output, that is, an output gap. When a policy causes output and hence incomes to rise, why must the net effect be adverse?

The direct effect is to raise output, which will raise current consumption and also private savings. The extent of the output increase will depend not just on the initial stimulus itself but also on the familiar multiplier, which, in turn, depends on the propensity to save. The current benefit is obvious; it reduces unemployment, raising output and incomes, and hence consumption. But what about the future?

The higher savings that finally result must be put in the balance when assessing net gains or losses for the future. These savings can finance the extra taxpayer liabilities created by the higher debt. In addition, there are the benefits for the future of the investment, for example infrastructure, that the government may have made as part of its stimulus program. Thus there are several future gains that must be set against the burden on taxpayers that higher debt creates. And, in addition, one must take into account the possibility of some of the government’s bonds being bought by the central bank, so that part of the debt is money-financed, rather than being financed on the market.

All this concerns the discretionary part of the stimulus. In addition, there are the automatic stabilisers. Here it is important to bear in mind that it is not enough that a tendency to budget deficit in a recession is automatic. These deficits must actually be financed if there is to be a stimulus effect. When there is a belief that budget deficits are undesirable (as there was in the Great Depression) it is likely that they will be quickly eliminated with higher taxes or reductions in government spending, rather than being debt-financed.

These and other issues are discussed rigorously in CEPR Policy Insight No. 34, which takes a close look at the Keynesian theory underlying the policy of fiscal stimulus being undertaken or considered in many countries, led by the US.

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