June 2, 2008 | posted by Michael Baxter in Oil |

We all know oil is expensive.  But is it too expensive – can we afford oil at present levels, and if not, surely it will come crashing down soon, like it has always done in the past?

Maybe the key to this lies in how expensive oil is in comparison to previous levels.  Okay, it reached an all-time high over a year ago, but, after allowing for inflation, it was only last autumn that it passed the levels seen in the early 1980s.

But since then, it has gone on rising, so that today it is around 60 per cent up the 1980s level, even after allowing for inflation.

In the past when oil was so high, demand fell back.  In the US, you may recall, the government responded to one oil shock by reducing the speed limit – something which is still in place today.   We all started to look for more fuel-efficient cars – do you remember that TV ad showing how far a car could go on one gallon of petrol?

Today we are seeing signs of falling demand for SUVs, that’s why in the US the likes of GM and Ford are suffering, and Toyota, which read the signs so ably, is thriving. Mind you, even Toyota is feeling the pressure.  According to this morning’s FT, the Japanese car manufacturer is now considering downgrading its sales forecasts for the US – because even it over-estimated by how much sales of pick up trucks and other bigger vehicles were going to fall.

In the UK, recent data from HM Revenue & Customs on VAT receipts has indicated a year on year fall in the amount of petrol we have been consuming.

But there are reasons to assume we have not yet reached the point when the price of oil is so high, where demands starts to fall quite rapidly.

For one thing, in China, and certain other developing countries, oil is subsidised.  The Chinese consumer is not yet feeling the full cost of the rising price of oil.  The Chinese government is, of course,  because it is footing the bill associated with the subsidies.

It is not good.  When oil is subsidised the market is distorted.  Demand is not allowed to adjust the way it should.  But presumably, there will come a time when the cost of subsidising oil is just too high. At that time, demand, even in China, will start to fall.

But there is an even more significant reason why the price of oil may not yet be ready to begin its descent. 

As Hamish McRae pointed out in the Independent this morning, right now around 6 per cent of world GDP is spent on oil. This is a big increase on the percentage spent in the late 1990s and earlier this decade, but at the end of 1979 the proportion was higher – around 7 per cent of GDP.

But in this morning’s FT, John Authers in his daily video broadcast pointed out that according to data from Societe Generale, after allowing for inflation oil would need to rise to around $190 a barrel before the oil burden – that is to say the price of oil, times the amount consumed divided by GDP – hits the levels seen in the early 1980s.

And that really is a blow – because this data suggests oil might have further to rise before demand begins to fall sufficiently to bring price down.  Indeed, this is precisely what future markets seem to expect.

So the bad news, oil may well have higher to climb yet, it may even break the $200 mark, as some analysts predicted recently.  Furthermore, this run may have some time left in it.   Don’t expect oil to start falling back any time soon.

This means, of course, it will continue to exert inflationary pressure.

But, in the past, when oil did fall in price, it did so rapidly.  Remember, not so long ago, oil was a fraction of the current price – less than $20 a barrel.
 
No one is predicting oil will fall that low again – the global economy is just too large – but it will surely fall quite significantly in due course. 

The oil market displays all the hallmarks of a bubble, and remember, when bubbles burst prices tend to fall too low.

The key probably lies with how long it takes for oil to drop, and what happens in the meantime.   If we see a sharp rise in salaries, or if interest rates fall so low that the high price of oil becomes more affordable, or if governments fiddle around with subsidies or taxes, again reducing the cost of oil directly paid for by the consumer, then it will take longer for the price of oil to fall back.  

If, on the other hand, we tighten our belts; if we accept that oil is expensive, and deal with it as best we can – then the inevitable fall will be sooner.

That is why pain now is what is required.  The real inflationary danger from oil lies with the danger that we try to avoid the pain through artificial measures.  And that is what we need to watch out for.