Crudely put, US$100 is nothing to fear

PUBLISHED : Tuesday, 04 December, 2007, 12:00am
UPDATED : Tuesday, 04 December, 2007, 12:00am

Judging by the hysterical note to much of the commentary last month when the price of oil came within a whisker of US$100 a barrel, you could be forgiven for thinking civilisation as we know it would be in danger of collapse if ever the crude price reaches three figures.

Happily, there is no need to worry. The models used to gauge the economic impact of a rising oil price are deeply flawed.

Back in April 2005, the Asian Development Bank forecast that every US$10 increase in the price of a barrel of crude oil would knock 0.8 of a percentage point off regional economic growth.

Just think about that for a moment. In making its projection, the ADB assumed an average price of US$41 per barrel for 2005. Yesterday, oil was trading at US$88 a barrel, having retreated from a record high of US$98 late last month.

So oil costs nearly US$50 more than the ADB assumed in 2005 and yet the bank is forecasting that emerging Asian economies will grow at a blistering 8.3 per cent pace this year.

That would mean, according to the ADB's rule of thumb, that if the price of oil had not risen over the past 2 ? years, Asia's economic growth rate this year would be a shade over 12 per cent. The mainland would be growing at a 15 per cent pace.

To put it another way, when the ADB made its 2005 forecast, it expected a 6.5 per cent regional growth rate. Factoring in the oil price rise we have seen since then, that would mean Asia should expand just 1.8 per cent this year rather than the 8.3 per cent the bank is now forecasting.

To be fair to the ADB, forecasting is a notoriously tricky game and anyone bold enough to make predictions is bound to end up with an egg on his face every so often.

Even so, models of the economic impact on Asia of rising oil prices have been proved wildly inaccurate.

That is partly because they are based largely on assessments of the oil price spikes of the 1970s. Those were the result of sudden interruptions in supply which had a direct and immediately negative impact on economic activity.

In contrast, the run-up over the last few years is, in large part, a consequence of the high demand generated by Asia's rapid economic development rather than a supply squeeze. As a result, the effect on growth is far milder.

In addition, it is likely the old models overstated the impact of rising oil prices 30 years ago. As Jean-Pierre Beguelin, chief economist of Swiss private bank Pictet points out, the spikes of the 1970s occurred during a period of financial turmoil involving sharp interest rate increases to control inflation, following the collapse of fixed exchange rates.

He argues that much of the economic slowdown attributed to higher oil prices was, in fact, due to the overall tightening of monetary conditions during the decade.

As a result, models which claim a definite relationship between the oil price and growth rates today should be taken with a large pinch of salt, says Mr Beguelin.

That does not mean the price of oil will not reach three-figure levels one day. Resurgent buying by hedge funds could easily push it up again, especially if fears of an economic slowdown turn out to be exaggerated.

But it does mean that even if crude does top US$100, we do not need to worry too much, whatever the models say.