Oil prices remain expensive. We at Bear Stearns and Co. are concerned that the negative impact on the global economy could compound as the oil shock is increasingly viewed as prolonged rather than temporary. We still expect oil prices to fall sharply, but note in this piece the mounting costs from expensive oil. The longer oil stays expensive, the more these costs mount. We have seen that there are direct costs associated with transferring from a productive market-based environment to one controlled by OPEC. (With world oil demand at 27 billion barrels per year, every $5 worth of OPEC quota power costs the world US$136 billion per year. That's 0.5% of world gross domestic product, or 5% of world fixed investment.) In addition, the world is paying an increasing indirect cost as some central banks respond to oil-related inflation. We think expensive oil is a primary explanation for the very high cost of capital in many parts of the world. Now we expect a broadening of oil shock into new areas. Consider that many processes have buffered the oil price shock, smoothing its impact in anticipation of lower prices in the future. But we may be reaching an inflection point in which the costs of expensive oil will accumulate at a faster rate as the buffers shielding companies, investors, and consumers expire. As examples, we note:
Rising aluminum and copper prices, as producers respond to higher energy costs.
Gasoline price increases in Indonesia, with Brazil and others expected, biting further into consumption.
Diesel price increases are passing more vigorously into transportation, seafood costs.
Reduced investment, as companies and governments wait to see where oil prices settle.
Tax increases coming in Turkey and Colombia as expensive oil forces austerity.
Currency weakness in Europe, Philippines, Thailand, South Africa, India, and Pakistan, accelerating the pass-through of expensive oil into inflation.
Interest rate threats. In its Oct. 3 announcement, the Fed said rising energy prices risked raising inflation expectations. Elsewhere, central banks already are acting. For example, the European Central Bank raised rates on Aug. 31, with another hike expected this month. Japan followed in September. In addition, the perception (we think false) that the United States has exhausted its policy options may erode the vital buffer provided by the U.S. status as "global superpower." We are surprised the United States hasn't taken more steps since releasing the Strategic Petroleum Reserve (SPR). Since the oil released from SPR has to be replaced, the release is simply a timing shift. Futures markets are adept at offsetting the effect of this type of surprise. We thought the administration would follow up the SPR release with a serious effort to bring future oil prices down. We expected some of the following measures:
Clear, effective requests to OPEC countries and Mexico to make helpful announcements (only Saudi Arabia has so far.)
Efforts to expand U.S. production.
A release of European oil reserves.
Steps to reduce OPEC's cartel power. Addressing OPEC is vital in order to restore market-based investment in energy production. But no official policy has emerged to counter the cartel's power. In an earlier piece, we reached too optimistic a conclusion: "Oil prices are distorting the inflation outlook and U.S. monetary policy. Now that the China trade bill is over the hump, Clinton and other officials will be able to focus on the politically vital issue of oil and gasoline prices (even OPEC knows they are too high)." We still think oil prices will fall sharply once inventories begin to build. Bear Stearns' oil analyst Fred Leuffer has shown that supply is exceeding demand, and that inventories are often a lagging indicator. We do not expect expensive oil to turn into a sudden crisis, even if prices remain elevated. However, as expensive oil is increasingly viewed as a prolonged problem, the costs for the world economy could broaden into new areas.
David Malpass is chief international economist at Bear Stearns and Co. in New York. This column was distributed by BridgeNews but does not necessarily reflect the opinions of BridgeNews.