The recent hike in oil prices could hardly have come at a worse time for Europe. The economic recovery from the effects of the financial crisis remains anaemic, and although Germany’s export sector is powering ahead, the UK’s return to growth remains fragile while smaller debt-laden countries such as Greece, Ireland and Portugal are struggling to convince financial markets of their resolve to fix their broken public finances.
Unsurprisingly, the recent price rally in oil markets – driven even higher by the unrest spreading in the Arab world – has spread further gloom in European capitals. In 2010 alone, it is estimated to have caused a loss of 0.5% of gross domestic product in the OECD countries. And according to calculations by the International Energy Agency, the oil price rise added $70 billion to the European Union’s import bill last year.
To put this sum into context, it is nearly the equivalent of Ireland’s budget deficit, or twice the deficit of Greece.
Economic historians like to point out that oil price hikes preceded nearly every major global recession since the Second World War. The last such episode was in 2008, when oil prices hit a record high of $147 a barrel. After a sharp fall back to $32 at the end of that year, the price of Brent Crude has risen again and has recently struck the $120 mark.
Will the rebound in the oil market bring the EU’s fragile recovery to an end? Such fears cannot be dismissed easily. Already, higher energy prices have pushed up inflation rates and are adding further pressure on central banks to raise interest rates. But whether oil price rises will wreak economic havoc depends, of course, on their duration. Consumers and manufacturers can absorb short-term shocks but will find long-term price rises more difficult to stomach.
But even if price pressures recede again as Saudi Arabia pumps more oil into global markets, European investors and policy-makers would be well advised to consider some of the long-term risks that will drive future oil market fluctuations.
On the economic front, the fundamental problem is that long-term demand and supply trends are out of sync. Global oil demand is set to rise year-on-year while global supply is coming up against natural, economic and political barriers. The net result of this will be higher prices overall, but also greater price fluctuation as markets adjust through repeated boom-and-bust cycles.
Demand is largely driven by the power-hungry emerging economies of Asia and Latin America. Increased energy efficiency and the off-shoring of energy-intensive manufacturing may have helped Europe to slow down the growth in demand for fossil fuels, but China and India are relentless in their quest to fuel an extraordinary export boom and to satisfy the aspirations of their expanding middle classes. China alone has single-handedly reshaped global energy markets in recent years. In 2009, China overtook the United States to become the world’s biggest car market. And a year later, the country pushed ahead of America as the world’s largest energy consumer. Just ten years ago, China’s energy consumption was only half that of the United States.
In the past, plenty of spare capacity and unexplored reserves allowed oil-producing countries to satisfy the growth in global oil demand. Production should continue to grow for several years to come, but the signs of a future tightening of the supply side are all too clear. Already, oil companies are having to search in ever more remote fields that drive up production costs and pose new environmental and commercial risks, as last year’s oil spill in the Gulf of Mexico demonstrated.
Moreover, the added capacity from new explorations is unlikely to fill future output gaps, as more and more analysts warn. A recent review by the UK Energy Research Centre concluded that, based on current knowledge, oil production from conventional sources is likely to peak before 2030, with a ‘significant risk of a peak before 2020’. To be sure, oil will not run out for many decades to come. But if future production will not be able to keep up with the energy thirst of the emerging economies, then upward pressure on oil prices will be inevitable.
The recent popular uprising in the Arab world further illustrates the global risks that threaten Europe’s economic future. The oil price rises since January are the direct result of the growing unrest in the oil- and gas-rich regions of North Africa and the Middle East. Even though they reflect not so much actual supply shortages but market fears about further contagion effects of the ‘Arab spring’, they underline the political volatility that characterises global energy markets. On their own, individual crises such as the near shutdown of production in Libya would be manageable. Once larger suppliers are affected, however, panic can easily grip global markets. Should unrest spread to Saudi Arabia – an unlikely scenario in current circumstances – the outlook for the European economy would indeed be bleak.
Text: Dr Robert Falkner, London School of Economics
Date: 2011-05-22