UK: Economic Review -The impact of high oil prices on the UK economy - Fourth Quarter
A slippery slope?

Foreword by John Connolly

This Review comes to you at a time when a record high oil price is casting a shadow over world economic growth and is threatening a return to the inflationary era of the 1970s. However, Roger Bootle, our Economic Adviser, expects that the economic impact of a higher oil price will be much less devastating this time around.

Moreover, Roger believes that the UK economy is in a better position to be able to cope with a higher oil price than the other leading economies. For a start, of the G7 nations the UK is the least intensive oil user. On top of this, the UK is one of just two net oil exporters in the G7, which places it in a privileged position where the extra revenue from a higher oil price could be used to offset the adverse impacts elsewhere. And finally, high rates of petrol taxation are actually a benefit in this instance, as the proportional increase facing consumers will be less than in countries with lower petrol taxation.

Nonetheless, Roger believes that the world economy is set to experience a slowdown in the coming year or so, with the recent soft-spot in US activity likely to develop into a sustained slowdown and activity in Asia soon to come off the boil. The UK is unlikely to escape unharmed, as the consumer and housing market slowdowns continue to develop but despite a major housing market adjustment, the UK economy will avoid recession, not least because the Monetary Policy Committee has plenty of scope to cushion the blow by cutting interest rates.

Once again, I hope that this Review helps you in both your immediate and strategic thinking.

• Given the UK’s disastrous experiences following the oil price shocks of the 1970s, it is no wonder that the recent increase in the oil price has fuelled talk of rising inflation and the threat of recession. But we think that the impact on the UK economy from a significant rise in the oil price would be relatively minor.

• To start with, the increase in the oil price in the last year bears no resemblance to the huge rises of the past. And in real terms, today’s oil price is nearly half of the peak seen during the late 1970s.

• Moreover, even if the oil price did shoot up towards this peak, the impact on inflation and activity would be reduced by the absence of the other factors that magnified its impact in the 1970s, such as the collapse of the international monetary system, high trade union activism and poor monetary policy management.

• In other words, the economic problems experienced in the 1970s that we commonly attribute to the increase in the oil price were really due to the wider failures of the economic system, which have now been largely remedied.

• What’s more, the UK economy appears to be in a better position to cope with a higher oil price than the other leading economies. Indeed, of the G7 nations it is the least intensive oil user.

• Furthermore, the UK is one of just two net oil exporters in the G7, which places it in a privileged position where the extra revenue yielded from a higher oil price could be used to offset the adverse impact on other areas of the economy.

• And finally, somewhat paradoxically, the UK’s high rates of petrol taxation cushion the blow from a higher oil price as the proportional increase facing consumers will be less than in countries with lower petrol taxation.

• Overall, then, although sharp increases in oil prices are not a thing of the past, we think that oil "shocks" in the traditional sense are.

• Elsewhere, the global economy has recently entered a soft-patch which is likely to develop into a sustained slowdown in the next year or so, as economic activity in the US and Japan comes off the boil.

• The UK is unlikely to escape unharmed either, as the developing consumer and housing market slowdowns are likely to reduce GDP growth from 3.3% this year to around 2.3% next year.

• And as the housing market slowdown gathers pace, the Monetary Policy Committee is likely to cushion the blow to the rest of the economy by cutting interest rates to 4.5% by the end of 2005 and 4.0% by the end of 2006.

High oil prices came back to haunt the world economy during the summer of 2004. In rising to $45 per barrel the price of brent crude oil surpassed the peaks seen during the first Gulf War in the early 1990s and triggered flashbacks to the global recessions that accompanied the two oil price crises of the 1970s. Could oil again deal a devastating blow to the UK economy?

A good place to start is to assess the size of recent increases in the oil price. At $45-50 pb, the oil price may be at an all time high in nominal terms, but in real terms the price is nowhere near as high as it reached at the peak in 1979. As Chart 1 shows, the oil price would have to rise to $80 pb in today’s money to represent the same level it soared to in 1979.

Moreover, the rates of increase this year bear no comparison with the huge rises of the past. In August this year oil prices were 38% higher than they had been a year earlier and 50% higher than they had been two years earlier. By contrast, in early 1974, oil prices were almost 400% higher then they had been just over a year earlier, and in late 1979 they were almost 200% higher than a year earlier. Even in the much milder upsurge in 1990, they rose by 125% in four months.

Nevertheless, in 2004 the oil price has stayed higher for longer than most analysts have expected, and it may yet rise further. Accordingly, it is important to analyse the effects on the British economy. In this article we assess the likely impact of a 40% rise in the nominal oil price, which is similar to the rise in the price from $30 pb at the end of last year to around the levels of just over $40 pb ruling in the middle of this year.

So far, across the industrialised world, this increase appears to have caused only a mild rise in the inflation rate and a modest slowing in economic growth. But we ask what effects there would be from a further 40% rise. Our conclusions could readily be scaled up to cope with much larger increases that would take the oil price to $80 pb or above.

We analyse the impact on the following four areas of the economy:

• Inflation.

• Output and activity.

• The current account of the balance of payments.

• The government’s tax revenues.

A higher oil price will first and foremost be reflected in higher petrol prices. In the past a 40% rise in the oil price has been consistent with the petrol component of the consumer price index (CPI) adding an extra 0.2% to the price level.

This increase seems surprisingly low, but remember that in the UK, a huge proportion of the price at the pumps is accounted for by petrol duty, which will be unaffected by the rise in the price of oil.

But this is only the start. In addition, producers will be faced with higher raw materials costs. A 40% rise in the oil price would usually be associated with a 4% rise in the annual rate of input price inflation. But as producers’ spending on raw materials and fuels accounts for about 15% of their total costs, we would only expect output prices to rise by around 0.6% in response.

We can arrive at a combined estimate of these two effects by looking at the impact on prices at the whole economy level. In 2003, the UK economy spent just under 1 penny on oil for every pound of economic output created. Accordingly, a 40% increase in the oil price would increase the general price level, broadly defined, by around 0.4%.

As this is based on the assumption that all of the impact from a higher oil price is passed through into higher prices, this forms the upper limit of the effect of a 40% rise in the oil price. And if producers absorbed all of the impact in their margins, then we would just be left with merely the direct 0.2% rise in the price level from higher petrol prices.

Accordingly, we estimate that the immediate impact on the price level from a 40% rise in the oil price would be somewhere between 0.2% and 0.4%. This range, however, does not take account of knock-on effects from higher oil prices on other energy sources, including gas, coal and nuclear power. As far as overall energy usage is concerned, in total these amount to twice as much as oil alone.

Accordingly, if the price of all of these rose in line with oil prices (and there are already strong pressures now) then the overall impact could be as large as 3 times our figures, making our upper estimate of the overall effect on the CPI roughly 1.2%. In practice, however, a rise of even this magnitude is unlikely.

The immediate impact on the inflation rate from a one-off rise in the oil price would only last a year, as the upward influence would then drop out of the annual comparison. The price level would be permanently higher but, other things being equal, the inflation rate would return to its original level.

The key question then is whether there would be any second-round effects. A higher oil price effectively acts as a tax on consumers by reducing their overall purchasing power. If workers seek to recoup this by securing higher wage increases, then the initial potentially one-off increase to the price level becomes a source of a higher continuing inflation rate. Indeed, this effect could proceed ad infinitum as wages and prices chase each other upwards.

In fact, the position is potentially worse than this since, once the higher inflation rate has become ingrained, people start to expect it and build it into their price and wage-setting behaviour, thereby giving inflation another upward push. In this way, theoretically, inflation could accelerate without limit. Indeed, something like this appears to have happened in the 1970s when inflation reached a peak of 27% in September 1975.

Interestingly, this year, inflation expectations, as represented by the difference in the expected yield on nominal and real bonds (break-even inflation rates), have recently risen in line with the oil price.

However, it would be extremely surprising if this process went very much further. The conditions in the economy are now radically different from the 1970s. The economic environment is much more competitive and this means that it is more difficult for a wage-price spiral to get going. At every stage, some of the upward pressure on prices and costs is likely to be absorbed in diminished margins or real incomes. In this way, the initial upward impulse to the UK inflation rate is likely to fade away to nothing.

Moreover, the existence of a credible monetary framework with an inflation target would act as an anchor for expectations.

So, although there is considerable uncertainty about this, because of the impossibility of knowing the extent of knock-on effects and any associated rise in inflationary expectations, we think it is likely that the effect of a further 40% rise in the oil price on the UK’s inflation rate would be likely to be minimal. Moreover, it would probably fade away to zero in less than two years.

In the 1970s, surges in oil prices caused not only higher inflation, but also sharp drops in output. Indeed, they were at least part of the reason why the UK fell into recession twice in that decade. Could the same thing happen again?

Higher oil prices stifle economic activity through two main channels. The direct impact occurs as higher oil prices effectively act as a tax on consumers and producers, reducing their spending power. The indirect impact is a result of falling global activity and the adjustment of consumers’ and producers’ behaviour to a more uncertain economic outlook. The best way to look at this is to think of the economy in two parts – the oil-consuming part – i.e. the overwhelming majority of it, and the oil-producing part.

In 2003, the UK economy consumed £9.7bn of oil, and, given that demand for oil is relatively inelastic this would be unlikely to change in the short-term if the oil price were to rise. Accordingly, after a 40% rise in the oil price, the aggregate economy would have to spend an extra £3.9bn, or 0.4% of GDP, in order to consume the same amount of oil. Although a good deal of this effect would at first fall on producers’ profit margins, eventually it would mostly fall on consumers. If they allowed this reduction in real incomes to reduce their spending, the reduction in household expenditure would amount to 0.4% of GDP. In practice, though, they would probably absorb some of the effect in reduced savings. So perhaps 0.3% is closer to the mark.

As for producers having to face increasing raw material costs, the impact is unlikely to be uniform across sectors as it would depend on their relative use of oil.

Surprisingly, the services sector is now a more intensive user of oil than the manufacturing sector.

However, this is a reflection of the increasing importance of transport and communication services, whose rate of petroleum expenditure per unit of output is particularly high at 7.9%. If we recalculate the oil usage of the services sector excluding transport, manufacturing's usage is more intensive.

As well as the direct impact on the profits of producers and the purchasing power of consumers, however, there will also be a knock-on effect on UK economic activity from the fall in global demand and world trade.

A study by the OECD suggests that a $5 pb rise in the oil price would result in a 0.2% fall in the domestic demand of the industrial economies. Given that a 40% rise in the oil price from the end of last year is more or less equivalent to a $10 pb rise, it would not be too implausible to suggest that in our scenario of a 40% rise, global domestic demand would fall by around 0.4%.

If this were reflected proportionately on the UK’s exports of goods and services then UK exports would fall by 0.4%, which would take about 0.1% off GDP growth, or roughly £1bn.

Over and above this, output could be affected by indirect effects on confidence. With activity somewhat depressed compared to what it would otherwise have been, there should be a straightforward negative impact on business investment. But bearing in mind the memories of what happened in the 1970s, the adverse effect could be much larger. Exactly analogous points apply to consumers.

Unfortunately, though, we are here in the realms of mass psychology and it is therefore impossible to be sure what the effects might be. Business investment is roughly 10% of GDP so if it fell by 10% then that would reduce GDP by about 1%. In current conditions, however, our judgement would be that the adverse impact on confidence, of both consumers and businesses, would be comparatively minor.

This means that putting together the adverse effects on exports and consumer spending, the overall impact on GDP might be to lower it by about 0.4%. Falls in investment could raise this to 1.5% (or even higher) but in practice the overall effect would be likely to be much lower.

To put all this into context, in 2003 GDP growth was 2.2%, and is expected to be 3.3% in 2004. Next year the Treasury expects growth to be 3-3.5%. So even a reduction in growth of 1.5%, if it were to occur next year, would reduce growth to something like 1.5-2%. This would be a significant effect but it is surprisingly small, given that the high oil price in the 1970s helped to send the UK economy into two deep and protracted recessions.

We must now look at the oil-producing sector. While a higher oil price will have a negative impact on growth in the non-oil sector, it will boost the profits of oil producers and have a positive impact on the current account of the balance of payments.

The UK’s oil production is worth some £13bn per year so a 40% rise in the oil price would increase revenues, and hence profits, by about £5bn, or 0.5% of GDP.

This means that the overall effect on the UK economy could be just about zero. However, this conclusion depends on some dubious assumptions, including that the oil companies’ extra profits somehow lead to extra spending in the UK, that the adverse effects on UK investment are minor, and that overseas economies are able to deal easily with the effects of higher oil prices.

The effect on the balance payments, however, depends not upon the value of oil production, but rather upon the value of the oil surplus. The UK’s oil surplus has been in decline for some time, and on a monthly basis the UK turned into a net importer in July 2004. However, there is still likely to be a surplus over the whole year and for our purposes we assume it would be similar to the £4bn surplus recorded in 2003. Hence, a 40% rise in the price of oil would increase the surplus by £1.6bn, or slightly more than 0.1% of GDP.

Moreover, there would also be a modest fall in imports as a result of the reduction in consumers’ spending power. Working in the other direction, though, and roughly offsetting this, there would be a fall in exports as a result of the hit to global activity.

In addition, there will also be an impact on the investment income component of the current account as oil companies that are located away from the British Isles (and hence whose sales are not recorded in the current account statistics) will repatriate their profits back into the UK. In the past a 40% rise in the oil price has been consistent with a 25% increase in the profits of oil companies located abroad. Given that profits of oil companies were £19.0bn in 2003, and if all of the increase were repatriated, then the investment income surplus would rise by around £4.7bn, or 0.4% of GDP.

So, overall, the current account might improve by £6bn per annum.

Higher oil prices supply the government with greater revenues through two channels – the revenue from increased spending on petrol and the rise in North Sea tax receipts.

As fuel duty is charged at a flat rate of 41.7 pence per litre, a higher oil price will not affect the £23bn approx that the government generated through fuel excise duties in the financial year 2003/04. But since petrol is also subject to VAT at the standard rate of 17.5%, higher petrol prices do generate higher VAT revenues. This would yield the government an extra £0.3bn.

However, consumers would reduce their spending on other items by the same amount in nominal terms, but not all this would be subject to VAT, thereby leaving a small net revenue gain.

The second revenue-raising channel is taxes on the profits of oil companies drilling offshore. The Treasury has estimated that a 5% rise in the oil price would, other things being equal, increase revenues by about £220m in the first year and £270m in the second. Accordingly, in the second year, a 40% rise in the oil price would increase revenues by £2.2bn.

However, account also needs to be taken of the adverse impact on income tax and other revenues if GDP growth were to fall. If GDP were reduced by 0.6%, or roughly £6bn, then based on a marginal tax-take of 40%, government revenues would fall by £2.4bn. This would offset the direct impact of higher oil prices on revenues. Clearly, larger adverse impacts on GDP growth would leave the treasury worse off, despite higher revenue from the oil sector.

Putting these figures into context, in the 2004 Budget the Chancellor projected that tax receipts would total £455bn in the 2004/05 financial year. So increases of £2-3bn would be small change and would have little impact on the wider fiscal position. Mind you, while the adverse effects of a higher oil price on output and activity should be transitory, the increase in tax revenues from the oil sector should be longer-lived.

This is all well and good, but what would happen if the oil price were to rise by more than 40%, or if it were to fall? Given the proportional nature of our calculations it is easy to estimate the impact of such scenarios by scaling our estimates up or down.

If the oil price were to rise to $80 pb – the same level it reached in 1979 in real terms – this would be an increase of 166% from the $30 pb at the end of last year, or a rise more than 4 times the size of our putative 40% increase. Accordingly, our earlier estimate should simply be scaled up by a factor of four. However, it is likely that the effect could be proportionately larger for bigger changes. In particular, there could be much larger second-round inflationary effects, as a wage-inflation spiral could take hold and inflation expectations could escalate. Nevertheless, even in these extreme circumstances, inflation would probably not rise by more than 2-3% at the outside, even if other energy prices rose in line with oil prices.

Why is it that if the oil price rose to the same level, in real terms, as it did during 1979, the resulting surge in inflation would be much more muted and the economy would probably avoid recession? It is tempting to conclude that the reason is that this is a false comparison because the percentage increase now would be much smaller than the increase which occurred in 1979. But this is untrue. As we pointed out at the beginning, in 1979 oil prices rose by just over 200% in a year. So an increase to $80 a barrel now, representing a rise of some 160% over last year’s price of $30 pb, would deliver a percentage increase broadly comparable to what occurred in 1979. (It is true, though, that this would fall a long way short of what happened in 1973/4.) So why would the adverse effects now be proportionately less than they were in 1979/80? We think there are three reasons.

First, the UK economy is now a much less intensive user of oil than it was in the 1970s, as a result of efficiency improvements and (despite the point made above about the energy intensity of the transport sector) the gradual shift in the economy towards the services sector.

Second, whereas during the first oil crisis of 1973-1974, the UK was reliant on oil imports, the discovery of oil in the North Sea meant that the UK has been an oil exporter ever since. As such, some of the adverse effects on output from a higher oil price can now be offset by the beneficial impact on the UK’s oil surplus. (Admittedly, as North Sea reserves are running out, how long the UK remains a net exporter remains to be seen.)

But the third, and most important, reason is not to do with oil at all. It is a question of economic structure and behaviour. It cannot be denied that the high oil price contributed to the sharp rises in inflation and the sharp falls in activity in the 1970s. But it was not the only guilty party. In the early 1970s, the international monetary system collapsed, which took away the anti-inflationary anchor, and the monetary authorities were at sea as how to respond. Moreover, militant trade-unionism and non competitive business structures dominated the economic scene. These factors were both an independent source of inflationary pressure and a major contributory factor to the inflationary impact of higher oil prices.

Furthermore, a good part of the adverse impact on output surely came from the sharp rise in interest rates and bond yields made inevitable by the upsurge of inflation – as well as from the associated decline in confidence.

Accordingly, the impact from the oil price increase itself may not have been as devastating as folklore has led us to believe. In other words, most of the ill effects that we commonly attribute to the oil price rise of the 1970s were really due to the deficiencies of the wider economic system – deficiencies which have now largely been addressed.

Is the UK better placed to cope with higher oil prices than its international counterparts? Our analysis suggests that the effects for the other leading economies would be similar. But there would be some minor differences. Whether the UK is in a comparatively better position is determined by four factors: the relative dependence on oil; whether different countries are net importers or exporters of oil; the level of domestic taxation; and the response and credibility of the monetary authorities.

Of the G7 nations and the euro-zone, the UK consumes the least amount of oil per $1000 worth of output. Admittedly, some countries are always going to be more dependent on oil, such as the US and Canada whose climates require substantial expenditure on air-conditioning and heating, and whose sheer geographical size requires a lot of travel and transport per unit of output. But it may be true that the UK has made greater efficiency improvements. Whatever the reasons, though, a higher oil price is likely to have less of an impact on the UK economy.

Secondly, the UK is only one of two net oil exporters out of the G7 nations, with the other being Canada. With an oil surplus of 0.3% of GDP, a 40% rise in the oil price would increase the surplus by 0.1% of GDP. For countries such as the US and Italy, by contrast, their deficits would rise by 0.4% and 0.5% of GDP respectively.

This puts the UK and Canada in the privileged position whereby they could use the extra tax revenues yielded from the higher oil price in the near-term to offset some of the adverse effects on consumer spending or companies’ profits.

Thirdly, and paradoxically, the UK may be in a stronger position to withstand the impact of higher oil prices because of its high rate of tax on petrol, Chart 8 shows that tax makes up a larger percentage of the petrol price in the UK than in any of the other G7 nations. This means that the proportionate increase in prices facing consumers in response to a higher oil price, and hence the effect on the price level and on incomes, is lower in the UK than in other countries. Accordingly, the inflationary impulse should be weaker. So ironically, there is at least one benefit from high levels of petrol taxation.

Lastly, the UK’s policy framework puts it in a favourable position. Rising oil prices place the policymakers in a bit of a quandary – should they raise interest rates in order to hold back inflation or should they reduce interest rates in order boost activity? Faced with this dilemma in the mid-1970s, the monetary authorities in the US, France, Italy, the UK and Canada initially chose to pursue accommodative policies. It is generally perceived that this was a mistake as it allowed the resulting price increases to get incorporated into inflationary expectations which made inflation persistent.

This mistake is unlikely to be made again in any of the leading countries. As we now know, the authorities will be better placed to navigate these treacherous waters, the greater is their credibility. The authorities’ credibility is now much higher, in almost all countries, than it was in the 1970s. Indeed, the credibility of the monetary frameworks in the leading economies is probably one reason why inflation expectations have remained low in the last year, even though the oil price has risen substantially.

But the UK authorities may be in a better position to anchor inflation expectations given the flexibility of the labour market and the clear and precise definition of the 2% CPI inflation target. In contrast, although the European Central Bank has an inflation target there is a lot of ambiguity surrounding its definition of "close to but less than 2%". And even though the US Federal Reserve has recently proved itself apt in influencing market behaviour, it does not have an explicit inflation target.

The upshot is that not only would a 40% rise in the oil price be unlikely to have much impact on the leading economies, but that the UK is probably better placed to withstand higher oil prices than most of the other countries.

We must of course, beware of complacency. A 40% increase would be just about one tenth the size of the increase which rocked the world in 1973/4. An increase of that magnitude, were it to happen again, would still have very serious consequences although, for the reasons analysed above, these would be much less than before. Indeed, it is noteworthy that in real terms, the oil price is already at the level it reached after the oil shock of 1973/4. Admittedly, the world recovery has wobbled a bit but the world has hardly collapsed into recession. Has oil lost its power to shock?

This idea is bound to be surprising given our troubled history. Yet before 1973 hardly anyone would have imagined that a surge in oil prices would take the UK to the brink of hyper-inflation and twice plunge the economy into recession. What is happening now is that oil is getting back to its earlier status. Some of this is due to changes in oil’s importance relative to the economy. But the biggest effects come from changes in economic structure and behaviour. The very severe adverse effects that we have commonly attributed to the increases in the oil price in the 1970s were really due to the wider failures of our economic system. Now, these have largely been remedied.

Sheikh Yamani, the former Saudi Oil Minister and architect of OPEC, once said that just as the Stone Age ended, but not through a shortage of stones, so the Oil Age would some day end – but not through a shortage of oil. Sharp oil price increases are very much still with us, and the Oil Age is certainly not yet over – but the age of oil "shocks" probably is. 

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