Hi,
6K and Ms How. The article called “crude threat” is about the impact of the increase in oil price on the global economy. It talks about both the current condition and what will happen in the future.
Buttonwood
Crude threat
May 15th 2008
From The Economist print edition
High oil prices may yet damage the global economy
A COUPLE of years ago, those who forecast that oil would reach $100 a barrel were seen either as doomsayers or publicity-seekers. Now some are predicting $200 oil—and are taken deadly seriously.
This paragraph suggests that there is a significant change in consumers’ expectations of the price of oil. This may further encourage speculative buying, resulting in an even larger and steeper increase of oil prices.
Had economists been told that oil would barely pause at the century mark before reaching the recent peak of nearly $127, they would no doubt have forecast dire economic consequences. But the global economy, although rattled by the high price of energy, is still chugging along. Meanwhile inflation has picked up, but headline rates in most developed countries are nowhere near the levels seen in the 1970s and 1980s.
The global economy is still making slow but steady progress. Also, the problem of inflation is not as serious as compared to the 1970s and 1980s. The surging oil price seems has a less impact on the global economy than expected.
There are three explanations for the oil price's muffled impact. The first is that nowadays developed economies are more efficient in their use of energy, thanks partly to the increased importance of service industries and the diminished role of manufacturing. According to the Energy Information Administration, the energy intensity of America's GDP fell by 42% between 1980 and 2007.
Here the author starts to explain the reasons for this phenomenon. There is a shift in focus of the economy of the developed countries from manufacturing to service industries. According to U.S. Census Bureau Economic Programs, the services industries account for 55% of economic activity in the U.S. Usually, manufacturing industries requires large amount of energy per unit of output and incurs large amount of energy waste at the same time. Therefore, the demand of manufacturing for oil is very large. However, energy required is much lower for service industries. In addition, the developed countries’ method of production is better. For example, there is less wastage of energy. This is illustrated by the 42% fall in energy intensity in U.S. (Energy intensity is a measure of the energy efficiency of a nation’s economy. High energy intensities indicate a high price or cost of converting energy into GDP.) Thus, there is a decrease in demand of oil in developed countries.
A second theory is that the oil-price rise has been steady, not sudden, giving the economy time to adjust. Giovanni Serio of Goldman Sachs points out that in 1973 there was a severe supply shock because of the oil embargo, when the world had to cope with 10-15% less crude almost overnight. Not this time.
The sudden increase in oil price in 1973 is because of insufficient supply. The demand for oil is very price inelastic. This change is sudden, so the consumers will not have time to adjust. Thus, the impact on the economy is huge. This time the increase in oil-price is mainly due to the demand factor. In other words, the supply is quite stable. The demand for oil is relatively more price elastic. Therefore, the consumers will have time to adjust their consumption patterns (use less oil-consumed method of production) and find alternatives of oil. Hence, the impact on economy is less.
The third explanation turns the argument on its head; rather than oil harming the global economy, it is global expansion that is driving up the price of oil.
The most important factor is the shift in favour of the developing economies. America has responded to high prices in familiar fashion: UBS forecasts that demand will drop by 1.1% this year and will be no higher in 2009 than it was in 2004. But demand from China and other emerging markets is more than offsetting this shortfall. With supply growth sluggish, the steady increase in demand is hauling prices remorselessly higher. Alex Patelis of Merrill Lynch reckons it would take a recession in emerging markets to drive commodity prices substantially lower.
It suggests that it is the economy which affects the oil price rather than the oil price which affects the economy.
The best-known pessimist on the oil price's link with global growth is Andrew Oswald of the University of Warwick. In March 2000, at the height of the dotcom boom, he argued that the world economy would slow in response to higher oil prices just as it did in the 1970s, early 1980s and early 1990s. Although his argument was brushed aside at the time, there was indeed a slowdown in 2001 and 2002.
Even so, his argument looks harder to sustain this time, given that a fourfold increase in oil over the past five years has been accompanied by some fantastic global GDP growth. Mr Oswald says the problem is that the lags are long, with few effects seen for at least 12 months. It may take as long as two years before a big impact appears, he reckons, during which time higher oil prices will have pushed up business costs, leading to a decline in profits and an eventual rise in the rate of unemployment.
Perhaps that transmission mechanism has not worked quite so quickly during this cycle because companies have been benefiting from the productivity gains of their investments in technology and from their outsourcing to Asian economies. But those gains may be starting to run out: profit growth, as a share of American GDP, peaked over a year ago.
In the future, the world economy growth will slow down as a result of higher oil prices. Yet the impact is not observed. This is because companies are able to enjoy internal EOS (lower cost of production as a result of their investments in research and development). Also, they are making huge profits in Asian markets. However, the profit may eventually disappear, as it is not enough to offset the increase in cost of production due to increase in oil prices. Therefore, companies have to lay off workers, consequently an increase in unemployment.
Companies are now facing a squeeze. Figures from Britain this week showed that firms had pushed up their output prices by 7.5% over the previous year but this rise, while startling enough, was nowhere near sufficient to compensate them for a 23.3% gain in raw-materials prices, the biggest since 1980.
Here is an example of increase in cost. In order to maintain profit/avoid losses, the suppliers have to increase price as the cost of production increases because of the 23.3% increase in price of raw-materials.
It will be even more difficult to maintain profit margins when consumers are under pressure. Again, higher oil prices are part of the problem. Goldman Sachs reckons that some $3 trillion of wealth was transferred from oil consumers to oil producers between 2001 and 2007 and the pace of transfer is running at $1.8 trillion a year. In general, producing countries save more, and spend less, than consuming nations. At the same time, of course, falling house prices in America, Britain, Spain and Ireland threaten to make consumers feel the pinch.
Since the consumers are more affected by oil prices than producers, wealth will be transferred from consumers to producers. In addition, the consumers are also suffering from the falling house prices.
Moreover, central banks may be unable to give consumers much help. With British inflation rising faster than expected, the Bank of England may join the European Central Bank, the Bank of Japan and the Federal Reserve in keeping interest rates on hold for the foreseeable future. So far oil has been the “dog that did not bark”; but it may yet give the global economy a nasty bite.
The impact can be lessened by the central banks as they are unable to lower interest rates. The developed countries have to keep interest rates on hold because of the rising inflation rates.
Yuhan
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