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The Macroeconomic Consequences for the UK of the Recent Increase in the Price of Oil

Posted on: Saturday, 30 July 2005, 03:01 CDT

Throughout 2004, there occurred a substantial rise in the price of oil. During the final quarter the price of Brent crude oil exceeded $50 per barrel for the first time. The marked increase stimulated economic commentators into contemplating the likely consequences for the UK economy. The consensus to emerge was that the effects on the UK economy would be relatively modest. While output growth would be adversely affected, the economy would not enter into a recession, in contrast to the experience in earlier decades. Also, it was believed that the UK economy would be more robust to the increase in the price of oil than either other European economies or the USA economy. This article presents reasons for the optimistic view of the ability of the UK economy to withstand a significant increase in the price of oil. However, it concludes by issuing the warning that, on account of demand as well as supply factors contributing to the recent price rise, the oil price may remain at a relatively high level for the foreseeable future.

At the time of writing this article, in February 2005, the price of Brent crude oil was equal to $44.63. Although the price had come down from a peak of over fifty dollars, recorded in October 2004, this still represented a 40% increase over its average value during the first quarter of 2004. Furthermore, this amounted to a rise of more than two-thirds over the average price of Brent crude oil during the first four years of the new millennium.

HISTORICAL AND THEORETICAL CAUSES FOR CONCERN

A reference to both history and economic theory encourages a pessimistic view of the consequences for the economy of a significant increase in the price of oil. In a seminal paper published in the 1983 edition of the Journal of Political Economy, James Hamilton drew attention to the fact that all but one of the post-World War II recessions in the USA had been preceded by an increase in the price of oil.

Diagram 1

Diagram 1 indicates that a similar correspondence has applied to the UK. The graph shows, over the period 1973-2003, the annual percentage change in the price of Dubai crude oil (PCHPOIL) and also in a volume measure of UK GDP (PCHGDP). Over the period concerned, it is apparent that the UK has suffered three major recessions. GDP declined by 1.35% in 1974, 2.06% in 1980, and 1.36% in 1991. Prior to each of these falls in output, there occurred a substantial rise in the price of oil. More specifically, with respect to the intervals 1972-1974, 1978-1980 and 1988-1990, the oil price increased by 448%, 174% and 54% respectively.

Within macroeconomic theory, the standard framework for analysing the consequences of a change in the price of oil is a model of aggregate demand (AD) and aggregate supply (AS). The AD-AS model is depicted in Diagram 2. The AD schedule indicates the quantity of output of the domestic country that is desired by households, firms, government and foreign countries at different price levels. The schedule takes the form of a downward-sloping line for the reason that the higher is the price level, the higher will be the rate of interest, and the lower will be private investment. Also, an increase in the price level will reduce international competitiveness and result in a reduction in the domestic country's net exports.

The AS schedule indicates the quantity of output that the domestic country produces at different price levels. The schedule has been drawn as an upward-sloping straight line, and applies to the short run. Within the Macroeconomics literature, different arguments have been provided for the existence of a positive relationship between the supply of output and the price level. One (New Keynesian) explanation that has been offered is that, in the short run, wages are fixed in nominal terms, on account of contracts that have been agreed to by employers and workers. Consequently, an increase in the price level results in a fall in the real wage, which renders it profitable for firms to increase their employment (and output).

Diagram 2

Using the framework of an AD-AS diagram, an increase in the price of oil has the effect of shifting the AS schedule upwards. The outcome is the same, irrespective of whether mark-up or competitive pricing is assumed. Upon observing Diagram 3, it is apparent that the upward shift of the AS schedule (to AS') produces simultaneously a higher price level (P^sub 2^) and a lower level of output (Y^sub 2^). Consequently, an oil price rise results in both price inflation and a negative growth of output, twin evils that have become known collectively as stagflation.

Should the government of the domestic country seek to restore output to its original level then there are two policy options available. One approach is to do nothing. In this case, the reliance is upon the relatively low level of output and high rate of unemployment to exert downward pressure on prices and nominal wages, such that, diagrammatically, the AS schedule will return to its original position. The alternative strategy consists of actively intervening, expanding demand through, for example, increasing government expenditure or lowering taxation. Diagrammatically, the AD schedule shifts to the right. As can be seen from Diagram 4, though, the cost involved is an even higher price level (P^sub 3^).

Diagram 3

Diagram 4

On the basis of the diagrammatic analysis that has been performed, it would seem that the output that is generated by an economy is determined by the position of the AS schedule, relative to the position of the AD schedule. While the recent increase in the price of oil will have had the effect of shifting the AS schedule to the left, there are other mitigating factors which encourage the belief that the UK economy will avoid entering into a recession.

THE CHANGE IN THE PRICE OF OIL, ADJUSTED FOR UK RETAIL PRICE INFLATION

An initial point concerns the movement in the price of oil, adjusted for general retail price inflation. Even though, in October 2004, the price of Brent crude oil, for the first time, surpassed fifty dollars per barrel, when expressed in real terms this represented only around 50% of its price in 1980. To be more specific, in 1980 the price of Brent crude oil averaged $36.83 per barrel. Also, in that year, the UK Retail Price Index (RPI) was equal to 70.70 (1985 = 100). The RPI subsequently reached 199.35 in October 2004. In order for the price of oil to have kept pace with the RPI, this would have needed to be 836.83 x (199.35/70.70), i.e. in excess of $100 per barrel.

THE CONSUMPTION OF OIL IN THE UK PER UNIT OF GDP

The UK is currently much less reliant upon oil to generate a unit of GDP than in earlier decades. Diagram 5 shows, over the time period 1972-2003, the consumption of oil in the UK, expressed both in million tonnes (CONSUMP) and as a proportion of a volume measure of GDP (CONSPERGDP). Upon viewing the bottom line in the diagram, it can be seen that, from 1972 to 1981, there occurred a sharp drop in the usage of oil. From 1981, though, far greater stability is apparent. With the exception of 1984, a year in which there was a miners' strike, oil consumption remained within the bounds of 72.4 and 84.0 million tonnes, per annum.

Diagram 5

Upon observing the top line in Diagram 5, however, a much steadier decline in the consumption of oil is visible. Indeed, the reduction in the dependence on oil per unit of GDP from 1981 to 2003 was marginally greater than from 1972 to 1981 (42.4% versus 40.0%). An article in the July 2004 edition of the National Institute Economic Review, by Ray Barrell and Olga Pomerantz, has shown that the fall in the oil intensity of output over the past twenty years is a feature of not only the UK but also France, Germany and the USA. Additionally, the article indicated that the reliance upon oil in the USA is in the region of 60% greater than in the three European countries. The implication is that, other things being equal, the USA will suffer more severe economic consequences from the recent increase in the price of oil.

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THE UK'S TRADE BALANCE IN OIL

In contrast to when the increases in the price of oil in the 1970s occurred, the UK now possesses substantial oil resources of its own. Indeed, out of the countries that comprise the G7, only the UK and Canada are net exporters of oil. Diagram 6 shows, over the period 1972-2003, the UK's net exports of oil (SITC 33), expressed as a proportion of current-price GDP (NXPERGDP). The diagram reveals that, since 1980, the UK has operated a trade surplus in terms of oil. In 2003, the surplus was only 16% of the peak proportion in 1983. Nevertheless, the recent rise in the price of oil will have promoted an increase in the net transfer of income from abroad to the UK.

Diagram 6

On account of the UK currently being a net exporter of oil, it follows that, when there occurs a substantial rise in the price of oil, the leftward shift of the AS schedule, shown earlier in Diagram 3, is accompanied by a rightward shift of the AD schedule. In contrast, when the UK's imports of oil exceeded its exports, such an increase in the price of oil would have resulted in both schedules shifting \to the left. Consequently, other things being equal, the loss in UK output emanating from a significant upward movement in the price of oil will be less severe in 2005 than it would have been in the 1970s. Also, the recent rise in the price of oil will be less damaging to the UK economy than to those economies which lack self- sufficiency in oil.

EXPENDITURE BY OIL-PRODUCING COUNTRIES ON UK GOODS AND SERVICES

The UK's balance of trade receives a stimulus from a significant increase in the price of oil not only because the UK is a net exporter of oil but also for the reason that the oil-producing countries allocate some of their extra income to imports of goods and services from the UK. Recently, oil-producing countries have displayed a tendency to spend their oil revenues more quickly than in the past. Consequently, in terms of world output, the effect of a given rise in the price of oil will be less contractionary in 2005 than in the 1970s or early 1980s.

Furthermore, as can be seen in Diagram 7, the UK benefits disproportionately from an increase in the income of the oil- producing countries. The diagram indicates that, in the year 2000, the UK was responsible for only 3% of world output, compared with 22% for the USA, and 17% for the Euro Area. In contrast, the UK's share of oil-producing countries' imports amounted to 6%, compared with 11% for the USA, and 26% for the Euro Area.

Diagram 7

IMPROVEMENTS IN THE OPERATION OF MARKETS AND THE MANAGEMENT OF THE UK ECONOMY

Improvements that have occurred in the operation of product and labour markets in the UK suggest that the economy is currently better equipped to resist a substantial increase in the price of oil than in the past. The introduction of greater competition in product markets has meant that firms now have less scope to pass on higher costs in the form of higher prices. Regarding Diagram 3, presented earlier, the upward shift of the AS schedule that is caused by a rise in the price of oil will be less pronounced than prior to the 1980s.

Also, the labour market reforms that have taken place in the UK over the past quarter of a century have resulted in wages being far more flexible. Should the real wage have the capability of falling during a period in which the oil price is increasing then a wage- price spiral of the type that characterised the 1970s can be avoided. The upward shift of the AS schedule will be less marked and the reduction in output will be less severe.

The general view of economic commentators is that there has been an improvement in the management of monetary policy in the UK as a consequence of the decisions to target price inflation (in 1992) and to grant the Bank of England independence (in 1997). In recent years, the Bank of England has succeeded in maintaining a low rate of price inflation, which has in turn subdued wage demands. On the basis that the Bank is able to retain its credibility during a period in which the oil price is increasing then this will serve to restrict the upward movement of the AS schedule and limit the loss in output.

REASONS FOR THE PRICE OF OIL REMAINING AT A HIGH LEVEL

This article has sought to present reasons for an optimistic view of the ability of the UK economy to withstand the recent significant rise in the price of oil, and to avoid entering into recession. However, the article concludes by issuing the following warning. Although the UK economy may be more resistant to a substantial increase in the price of oil than in the past, the factors underlying the recent price rise suggest that oil will remain expensive for the foreseeable future.

The recent increase in the price of oil is distinct from oil price rises in earlier decades in that it has been underpinned by demand as well as supply factors. The oil price hikes which occurred in the past were on account of war-induced concerns over disruptions to the supply of oil. While the recent increase in the price of oil can be traced to worries about production in Iraq, Nigeria, Russia, Saudi Arabia and Venezuela, an additional determinant is an increase in the world demand for oil.

Over the ten-year period from 1994 to 2003, the world consumption of oil (in million tonnes) grew by an average of 1.5% per year. Part of the responsibility for this increase lies with China. From 1994 to 2003, the consumption of oil by China almost doubled. The average annual percentage change was 7.0%, such that China's share of world oil consumption rose from 4.7% to 7.6%.

The present economic situation in China suggests that the rate of increase in the demand for oil is unlikely to slow. China is currently experiencing the fastest industrial revolution that has ever been witnessed. The annual growth of GDP has been in the vicinity of 9% for the past three decades. As China continues to expand its manufacturing sector, the requirement for oil will accelerate. Also, a change in the pattern of household consumption will contribute to a higher demand for oil. As incomes rise, a greater proportion of the workforce will be able to afford cars, household appliances and air conditioning.

An important factor governing the future price of oil is the strategy towards supply of the Organisation of Petroleum Exporting Countries (OPEC). In 2003, OPEC was responsible for providing almost 40% of the world output of oil. The most powerful country within OPEC is Saudi Arabia, which in 2003 accounted for just over 32% of the cartel's total production. Moreover, Saudi Arabia is the only member of the organisation which possesses any spare capacity.

There are two significant reasons for believing that Saudi Arabia will exert a tight control over supply in order to maintain a high price of oil. First, it should have vivid memories of earlier mistakes that were made in managing oil production. For example, in the early 1980s, overcapacity in the oil industry threw OPEC into disarray. Also, in 1998 the misguided decision to expand production, just as South East Asia was entering into its financial crisis, resulted in the price of oil falling to $10 a barrel.

Second, Saudi Arabia has a requirement for additional revenue to enable it to tackle certain domestic problems. One of these is security. Also, several of the oil-producing countries are characterised by a young and rapidly growing population, high unemployment and increasing public debt.

RECENTLY, OIL-PRODUCING COUNTRIES HAVE DISPLAYED A TENDENCY TO SPEND THEIR OIL REVENUES MORE QUICKLY THAN IN THE PAST

REFERENCES

Barrell, Ray and Pomerantz, Olga (2004), "Oil Price Shocks and the World Economy Today", National Institute Economic Review, No. 189, July, pp. 14-17.

Hamilton, James D. (1983), "oil and the Macroeconomy since World War II", Journal of Political Economy, vol. 91, No. 2, pp. 228-248.

Robert Gausden, Senior Lecturer in the Economies Department of The University of Portsmouth

Copyright Economics and Business Education Association Summer 2005

Source: Teaching Business & Economics

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