What’s the difference between an oil price increase and an oil price shock? At a recent conference, I used the phrase “oil price shock”, and a member of the audience asked: “Is an oil price increase bad?”
For oil sector consultants such as myself, an oil price shock is not the same as a price increase. Unfortunately, in the industry, we tend to use these phrases as though everyone knows the distinction. But of course, they do not. So let’s try to clarify the issue.
An increase in the oil price is not necessarily a bad thing. Oil prices today remain well below full replacement cost. At $60 per barrel on a Brent basis, the price of oil is at least $25 below that necessary to provide sufficient supply to both maintain current production and allow it to expand with the growth of the global economy.
Every oil-exporting country, every oil company, and all the oilfield services and equipment suppliers would like to see a higher price. Such an increased price would help not only Opec, but virtually every member of the oil sector.
Of course, a price increase would be bad for consumers, but as a practical matter, an oil price below $70 per barrel on a Brent basis should have no material effect on global GDP growth.
On balance, a price increase is in the interests of the entire industry, including Opec.
But how big a price increase? When does an oil price increase become an oil price shock? Interestingly, the industry has no agreed opinion. An oil price spike is often defined as an unsustainable price, or alternatively, as a price level high enough, or a price increase sharp enough, to cause an economic downturn in the advanced economies.
Ordinarily, a price which brings the world consumption expenditure on oil above 5 per cent of global GDP is typically sufficient to cause a wider economic downturn. In the United States, this figure is likewise about 5 per cent, which translates into about $125 per barrel on a Brent basis. Therefore, when we speak of an oil price shock, today, we are speaking of a price about this level of $125 per barrel on a Brent basis.
An oil price above this level – last reached in early 2011 – is ordinarily sufficient to cause a recession, as it did in Europe and Japan at that time. Indeed, the US itself only barely escaped recession in 2011, an escape which our research suggests is largely attributable to the shale oil surge which America has enjoyed since then.
Rapid increases in oil prices, even when the actual price does not reach the recession threshold, have also been linked to recessions in the advanced economies. In 1991, during the first Iraq war, oil prices shot up, but never reached the 5 per cent threshold. Nevertheless, the US entered into a short and shallow recession which has generally been attributed to this price spike.
In today’s terms, the equivalent spike might be a $30 per barrel jump in the price of oil over a two-month stretch. I doubt, however, that this would lead to recession. Until just a few months ago, the global economy had been accustomed to oil prices well over $100 per barrel for three years. A rapid surge of oil prices to, say, $90 per barrel would not, I believe, be sufficient to induce another economic downturn, although it would tend to slow economic growth.
Oil price shocks also tend to influence international relations. They will make oil exporters of all types strong and prosperous as long as high prices last. As noted above, they will usually send the advanced economies – the US, Europe and Japan – into recession.
By contrast, a spike will also tend to slow, but not stop, growth in the emerging economies, for example, China and India. Therefore, a price spike will tend to tilt the balance of power towards the emerging countries and away from the mature economies.
A modest price increase, at this point, is in the interest of all those in the oil business, including shale producers, the international oil companies such as Shell, service providers such as Baker Hughes and Schlumberger, and of course, Opec members. Indeed, such an increase is essential to the viability of the oil sector.
On the other hand, an oil price spike to $125 per barrel may not be in anyone’s interest. The oil exporters’ short-term revenue gains may soon be offset by falling demand and collapsing prices. Surging oil prices may damage the economies of Opec’s customers and throw off the balance of power internationally. Price spikes, as a general principle, are to be avoided.
So not all oil prices increases are the same. Today, an oil price increase is necessary, and within bounds, not harmful to the global economy. However, a price spike to $125 per barrel would be likely to provoke the same outcome as it did in 2011 – a recession in the advanced economies. This is the risk to avoid.
Steven Kopits is the president of Princeton Energy Advisors in Princeton, New Jersey.
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