Oil prices, having gone through the roof, are still hovering near the ceiling - above US$50 a barrel. Anyone with an interest in the economy and a sense of history will look at this price spike and wonder: what does this mean for Australia's economic future? Will high-energy prices drive the economy through the floor? Or is the 2005-06 energy price spike different from the OPEC-led price spikes of the middle and late 1970s?

The most sensible response to these questions is guarded optimism. The causes and magnitude of this price spike and changes in the structure of both the world and the Australian economies suggest that we have a much better chance of avoiding recession this time round. But substantial risks remain, and the policy response will be crucial.

This analysis should begin on a note of caution. Socrates supposedly said that he acquired one piece of wisdom during his life - an awareness of how little he knew. Economists need similar humility when they make predictions about the future of commodity prices and their effects.

What has happened to oil prices?

World oil prices began to rise markedly from early 2002 and spiked briefly to a peak of U$S70 in September 2005 - the highest nominal level ever - before falling between October and December 2005.

Figure 1: World oil prices (nominal)

Source: Wall Street Journal, monthly spot price, West Texas intermediate crude oil

However, while the latest peak appears extremely high, it remains well below the 1980 peak when adjusted for inflation over the period.

Figure 2: World oil prices (real)

Source: Wall Street Journal, US Bureau of Labor Statistics, monthly spot price, West Texas intermediate crude oil deflated by US CP re-based to October 2005 = 100

Other international energy prices, such as coal and natural gas, have also risen in recent years, driven largely by strong international demand. The relationships between these international prices and domestic prices in Australia are much more complex than for oil, however, and there is little comprehensive data on domestic prices.[1]

Causes of the oil price spike

The main factor behind the rise in international oil prices has been strong global demand with which supply has not fully kept pace. World oil consumption grew by 3.7 per cent in 2004, with about a third of this growth coming from China.[2].

Four reasons for optimism

There are at least four good reasons for optimism about the economic outlook.

1. Real oil prices are still well below their 1980 peak. While average city petrol prices rose about 19 cents a litre over the year ended the September quarter 2005, average weekly household consumption of 35 litres means an additional cost of less than $7 per week.[4] This is about the same cost as the rise in repayments on a 0.25 per cent increase in the interest rate on a $200,000 mortgage.[5] Automotive fuel is weighted at 3.8 per cent in the CPI and in 2004-05 it represented less than 3  per cent of household consumption expenditure as measured by the National Accounts. It is also a business cost, but the Australian economy's decline in oil intensity of the Australian economy means that this effect will be smaller than it was in the late 1970s.

2. Excess demand has caused the current high world oil price, while the price shocks in 1974 and 1979 were caused by OPEC supply restrictions. Demand-driven price rises are from strong economic activity, which bodes well for future economic activity. Further demand-driven price rises will start to curb demand and accelerate supply, which in turn will reduce pressure for further price increases.

3. Both globally and in Australia, oil intensity (that is, the quantity of oil used per unit of output) has fallen in response to the relative expansion of less oil intensive economic sectors - such as services - and continuing technical advances in energy efficiency in energy-intensive sectors. These advances were accelerated by previous oil price shocks.

ABARE has reported[6] that overall energy consumption per dollar of GDP in Australia fell by an average of 1.1 per cent a year during the 1990s and is expected to continue at that rate for the next 25 years.

Figure 3: Oil use relative to output barrels of oil used per unit of GDP, 1971/2 = 100

Source: RBA Statement on Monetary Policy, 7 November 2005, p. 58, ABARE, ABS

4. Around the world, and particularly in Australia, economies have also become far more flexible in handling shocks. At the time of the previous two oil shocks the Australian economy was at its nadir in the flexibility with which it handled economic shocks with a trifecta of poor institutional arrangements, all of which have been substantially improved. These include:

• Wage-fixing arrangements built on 'comparative wage justice' that radiated inflationary pressure from booming sectors. Wage setting is now far more flexible.
• Exchange rates set, and seen to be set, by government, whereas now exchange rates are set by the market. This has made minerals booms far less inflationary.[7]
• Monetary policy is now more independent with medium term price stability given a very high priority.

Risks in the outlook

A good 'reality check' regarding the optimism set out above can be gauged by reflecting on the premise that many economists predicted a much smaller economic impact than in fact occurred in previous oil shocks. This was for several reasons, including the fact that measurements of the relevant "elasticities" or responsiveness of supply and demand to price changes had only been measured using the smaller changes in price that had occurred in the past. The small changes against which the economic models were calibrated were swamped by the events of the first oil shock.[8] The larger the shocks that are experienced, the further we move into the unknown and the more likely "non-linearities" are to emerge. These falsify assumptions built into models and mock the economist's forecasting powers.

The greatest risk to world inflation and economic activity comes from the current lack of spare capacity in world oil production. Estimates by the US Department of Energy[9] suggest world spare oil capacity has fallen markedly in recent years, and only one million barrels a day of spare capacity is likely to be available this year, rising to 2 million in 2006. This latter figure represents only about 2.5 percent of world demand and could be easily wiped out by minor supply disruptions.

Matthew R. Simmons points out that the peak oil production of a number of countries has come and gone unnoticed.[10] He draws parallels between world production and the way individual wells peak and lose their productive capacity, saying that the world peak oil capacity may have passed.

Figure 4: World spare oil production capacity

Source: US Department of Energy, Energy Information Administration, Short-term Energy Outlook November 2005,2005 and 2006 Forecast by US Energy Information Administration

The apparent lack of spare oil production capacity means there is still considerable uncertainty about where international oil prices will go from here, with some suggesting that they could go over US$100 per barrel.[11] Relevant factors in this situation include the continued rapid growth of China and India, with the associated rapid increase in the number of motor vehicles, the current low level of world production capacity, a current shortage of refinery capacity and geopolitical risks in major oil producing areas.

The very different global supply outlook for minerals generally and for oil is also a substantial source of risk. Australia's export volume growth has been weak for several years. Forecasters are predicting that with rapidly expanding supply in most commodities, commodity prices can be expected to fall within two or three years. However, the greater constraints on oil supply compared with other commodities raises the prospect of deteriorating terms of trade as the commodities we export fall in price while the oil we import does not.

What forecasters say

The OECD was sanguine in its most recent Economic Outlook,[12] noting that there had been a broadening of world economic growth over the past few months beyond North America and Asia, which were already growing strongly.

For Australia, real GDP growth is expected to increase from 2.6 per cent in 2005 to 3.2 per cent in 2006 and 3.6 per cent in 2007. The CPI is expected to rise by 2.7 per cent in 2005 and 3.1 per cent in 2006, before falling back to 2.9 per cent in 2007.[13] Providing the commitment to medium-term price stability remains, brief periods of time when the CPI rises exceeds its target band of 2-3 per cent offers the least disruptive way for the economy to adjust to higher oil costs.

Click for ABARE's analysis of oil price scenarios.

The Reserve Bank of Australia (RBA), in its November 2005 Statement on Monetary Policy, noted that the global economy continues to grow solidly. It referred to the latest International Monetary Fund (IMF) forecasts, putting world GDP growth at 4.25 per cent in both 2005 and 2006, lower than 2004 but still historically strong. Higher oil prices appear not to have seriously retarded world economic growth. The RBA points out that while oil price rises have pushed up headline inflation, they have not fed into core inflation for the major economies.

For Australia, the RBA says growth in the economy has remained solid. It expects real GDP to grow by about 3 to 3.5 per cent for the next two years, despite its assumption that oil prices will remain at about US$62 per barrel.

Taken together, these studies confirm the in-principle reasoning sketched above - that higher oil prices are unlikely to be a serious negative for the world or for Australia. Even the most pessimistic scenario of ABARE - a major recession - is avoided, though it was recognised that there were significant risks to this outlook.

Appropriate policy responses

Many of the appropriate policy responses are in place. In other areas political considerations have already led to unfortunate, though far from disastrous concessions. Elsewhere, policy should be guided by a range of broad principles, which are set out below.

The greenhouse debate has familiarised policy analysts with the notion of 'no regrets' measures - measures that are economically beneficial in their own right, but which can be "foregrounded" for action given the assistance they may provide in achieving other objectives deemed particularly worthy. Many of the principles proposed here ensure that our regrets over action taken to adjust to higher oil costs are kept to a minimum. They also ensure that the benefits in terms of more efficient fuel use are maximised.

Policy should:

1. Ensure that energy price rises are accommodated within the Australian economy with the minimum disruption to low inflation. It seems clear that the fuel price rises are not threatening the achievement of 2-3 per cent inflation targets in the medium to longer term.[16]

2. Do whatever is possible to assist markets to adjust to the changed circumstances. This means allowing domestic prices to move in sympathy with international prices (although there is no harm in lower prices). The cancellation of petrol price indexation before the 2004 election was a very unfortunate signal, although it may have been a political circuit-breaker that avoided the much worse outcome - actual cuts in fuel excise that enjoyed widespread popular support.

A cautionary tale can be told about the lack of import parity pricing in 1974. Because Australian oil was not priced to import price parity at the time, we were less well prepared for the second oil shock of 1979 (when import price parity was in place) because the shift to less oil-intensive technology - for example, smaller cars - had not taken place to the extent that it would have under a higher price regime.[17]

Industry policy responses

In addition to these broad responses there will be calls for 'industry policy' directed to specific industries, which will play an important role in our response to oil scarcity. Those industries include energy production and refining industry, transport and transport equipment.

The appropriate backdrop to any industry policy response is that Socratic presumption of our own ignorance with which this article began. Policymakers cannot know what the price of oil will be in five years, and if it remains high, policy today can only provide the economic outline of the desirable adjustment. Policymakers today cannot know the technical detail of the adjustment: much of it will be the product of specific information about opportunities 'on the ground', and much will be the result of know-how that is developed (some of it here, but most of it offshore) in response to changing price incentives.

Policy should favour broad responses in all cases, rather than approaches that have governments second-guessing market conditions.

1. Generous incentives for research and development (R&D).

Australia's private sector R& D performance has suffered serious reversals since its dramatic improvement from the mid-1980s to the mid-1990s. But R& D will be crucial to maximise our ability to seize new opportunities that the new oil scarcity throws up and to economise on fuel to reduce our exposure to increased costs. It will be very difficult for governments to identify where these opportunities are most propitious. Hence, broad and generous support is warranted.

Within our energy sector, as indicated above, our export exposure to energy sources that compete with oil (particularly gas and coal) present us with major opportunities. In this regard, R& D into the means of mitigating greenhouse impacts of the production and use of such fuels will generate a 'double dividend'. It will help the Australian economy to optimise its opportunities and minimise its downside risks in an oil-scarce world. At the same time it will position us well for a world in which carbon emissions are internalised as a cost of production. Initiatives already under way - such as COAL21 and the Low Emissions Technology Demonstration Fund - appear to meet this need.

2. Extend price signals where possible.

The appropriate pricing of road use will enhance our economy's response to the new oil scarcity. Where greater cost recovery in road pricing would move freight to rail, substantial fuel savings could be expected.[18] Further, congestion taxes would reduce our economy's dependence on oil and lower costs more generally. With eastern states governments increasingly concerned about congestion, but still too timid to really engage on the issue, now is the time to broaden the reform debate to include congestion pricing.

3. Maximise integration with the world economy.

Contemporary opinion - including expert opinion - is often wildly wrong. In response to the first oil shock, Australia increased protection for the automotive industry. This underwrote a massive re-allocation of resources within the industry. Manufacturing of large cars (at which Australia was world-competitive) came to subsidise manufacturing of smaller cars. Though this sector was faster growing we were and remain extremely uncompetitive in it.

History is repeating itself. Just as there was heavy investment into larger less fuel-efficient vehicles such as Leyland's P76 on the eve of the first oil shock, so too there has been substantial investment in larger vehicles such as the Ford Territory on the eve of the latest oil shock. Demand for such large vehicles has fallen around the world in response to the new oil shock, and this will make life difficult - perhaps very difficult - for our large vehicle manufacturers, as over-capacity develops in this sector. In the next product cycle, the size of Australian cars may be scaled back somewhat in response. However, it should be understood that it is most unlikely that Australia will ever be competitive at making Corolla-sized cars. While Australian policy should do nothing to stop our own producers moving into this space, policymakers should be very wary of underwriting such ventures with additional assistance.

If, as the view seems to have been taken with fuel excise, it becomes politically necessary to be seen to be doing something to assist the sector, assistance should be of a kind that is most likely to generate competitive sources of supply when that assistance is withdrawn. That would include assistance, which is most likely to generate centres of production and/or expertise in Australia that are relevant to the global industry. These include large car manufacture, design and fuel efficiency engineering.

Summary: Sensible risk management

The above analysis gives cause for cautious optimism. But significant risks remain, especially given the apparent fragility of the balance between supply and demand for world oil stocks.

Policymakers must focus on preventing oil price increases from flowing on through wages into inflation, something they appear to have well in hand at this stage. At the same time, price signals must be allowed to reshape our economic structure to minimise the costs and maximise the gains offered by the new world of oil scarcity and uncertainty. Allowing oil prices to rise and better pricing of other resources that are not well priced at present (like road use and congestion) will economise on our use of oil, facilitate greater investment in oil exploration and production, and the development of alternative sources of energy. All these things will allow Australia to take advantage of the undoubted opportunities that high oil prices have for our economy.

Normally, the further out a prediction is the less certain it is. In the case of oil this may not be so. Though we cannot predict when the world will reach its peak production level, this may be within a decade or so.

Amid the uncertainty, we can be confident of two things:

1. Despite common anxieties that the oil depletion will plunge us into a dark age, something more prosaic will occur. We will move to the next lowest cost options, which by that time may not entail great costs.

2. The better our response to our current difficulties, the better placed we will be for handling that perhaps more difficult, oil-depleted world.

References

[1] The Chief Executive of the Energy Networks Association has indicated that there is no relationship between international oil prices and domestic well-head gas prices in Australia.

[2] See IMF Paper, The Structure of the Oil Market and High Prices, Beckman P., Ouliaris S., and Samiei H., 21 September 2005, p. 3.

[3] Australian Commodities Forecasts and Issues Vol. 13, No. 3, September quarter 2005, Australian Bureau of Agricultural and Resource Economics.

[4] See Statement on Monetary Policy, Reserve Bank of Australia, 7 November 2005, p. 57.

[5] Some commentators have argued that the price rises may have obviated the need for a further rise in rates; see Nicholas Gruen, "Dodging Another Economic Bullet", Courier Mail, 2 November 2005.

[6] Australian Energy National and State Projections to 2029-30, Muhammad Akmal and Damien Riwoe, ABARE October 2005.

[7] Gruen, D. and Shuetrim, G. 1994, "Internationalisation and the Macroeconomy", in Lowe, P. and Dwyer, J. International Integration of the Australian Economy, Proceedings of a conference, Reserve Bank of Australia pp. 309-63.

[8] Dixon, P. 'Speech on Accepting the Award of Distinguished Fellow of the Economic Society of Australia', 30 September 2003, available at: http://www.monash.edu.au/policy/dfapbd.doc.

[9] See "Oil Remains Economic Bogyman", by Ed Shann, Australian Financial Review, 28 November 2005, page no

[10] Matthew R Simmons, Chairman Simmons and Co, presentation to the ASPO USA Denver World Oil Conference, Denver, Colorado, United States, 10 November 2005.

[11] See Roubini Global Economics Service, www.rgemonitor.com/blog/roubini/102398.

[12] OECD Economic Outlook No. 78, Preliminary Edition, November 2005.

[13] By contrast, the RBA expects underlying inflation to drift up, following growth in labour costs, but does not expect it to rise above about 3 per cent in the medium term. It will of course act to reduce underlying inflation if it threatens to break out of its 2-3 per cent target band.

[16] Stevens, G. Economic Conditions and Prospects October 2005, Hobart, 11 October 2005. more info

[17] A good discussion of these issues is provided by Dr Hugh Saddler, Managing Director of Energy Strategies, in "Another Shock May Make Us Realise We've Been Living in a Fuel's Paradise", Sydney Morning Herald, 30 June 2005.

[18] See, for example, Affleck Consulting 2002, "Comparison of. Greenhouse Gas. Emissions. by Australian Intermodal Rail and Road Transport", p. 7, available at: http:// www.networkaccess.qr.com.au/Images/Emissions_tcm10-2847.pdf