ANYBODY writing about oil prices and their economic consequences is well advised to remember J.K. Galbraith's dictum: "The experience of being proved completely wrong is salutary. No economist should be denied it and none are." Here's what he means:
In 1998, when oil was $US10 a barrel, a leading international journal forecast it would fall to $US5 a barrel and stay there. In June that year the average price of petrol was 71.4c a litre in Sydney and 68.7c a litre in Melbourne. This week the oil price topped $US60 ($78) a barrel and according to figures from Shell, the average petrol price this June is 106.7c a litre in Sydney and 105.5c a litre in Melbourne. It is tipped to reach $1.20 a litre in July.
The OPEC-induced oil price shocks of the 1970s, when the oil price hit a peak of almost $US40 a barrel in 1979, introduced the world to a nasty new economic disease: stagflation. This time around the price of oil has jumped from $US28 a barrel in late 2002 to more than $US60 now and the world economy is growing strongly, with low inflation. This is at odds with the rule of thumb developed by the International Monetary Fund, the International Energy Agency and the Organisation for Economic Co-operation and Development. According to their rule, every $US10-a-barrel increase in the price of oil cuts OECD area growth by 0.5 per cent and raises inflation by a little more than that.
There are some big issues here for the global economic outlook, but most Australians are more interested in petrol prices and their impact on their pockets. Labor and motorists' organisations are demanding the Government do something - silly, but predictable.
Prime Minister John Howard and Treasurer Peter Costello are well aware that petrol prices can be a hot political issue. Their response is to say higher prices are not their fault, rising world oil prices are the villain. They cut petrol excise from 44c to 38c in 2001 and pegged it there. As for the GST, Costello admits it does put up petrol prices, but says all the money goes to the Labor states.
All this political persiflage can be ignored. Australia has the lowest petrol prices in the world after the US and Canada. A strong case can be made for reducing our dependence on oil, but neither the Government nor Labor will consider policies that push up the price of petrol.
Will higher oil prices hit an already slowing Australian economy? According to a Reserve Bank analysis last year, there might be a small negative impact, and since then petrol prices have gone up again. But the RBA thought the effect would be smaller than in most countries. Australia, remember, is a net exporter of energy. Oil prices were given only a fleeting reference in a speech by RBA governor Ian Macfarlane two weeks ago.
Economist Craig James, from the Commonwealth Bank, produced an interesting analysis of petrol prices and consumer spending on Monday. It shows Australians have cut their spending on petrol, with a record 7.3 per cent fall in the March quarter, and cut spending on other discretionary items such as cafes and restaurants.
But spending on petrol accounts for a declining proportion of the household budget, at 2.8 per cent of consumption spending and 1.32 per cent of average weekly earnings. Over the past five years the increase in spending on doctors, dentists and hairdressers has gone up much faster than spending on petrol.
James concludes that while petrol at a $1.20 a litre may put a crimp in household spending, it is likely to be temporary - offset by rising wages, a strong jobs market and the coming tax cuts. This still leaves us with the question of why the developed world's economic response to a sharp rise in petrol prices has been so different this time, compared with the '70s.
One reason commonly pointed out is that if we look at petrol prices in real (inflation-adjusted) terms, the the oil price would have to rise to nearly $US100 to match its 1979 peak. At least as important is that this time around the rise in price has predominantly been driven driven by strong demand as a result of strong world growth, not a sudden cut in OPEC oil production.
As with other commodity prices, the surge in demand has run into supply bottlenecks, but production will increase in response to high prices. OPEC and other oil producers understand it is not in their interest to push prices to the point where they cause a global recession and oil prices crash. As a result of the earlier episode of high oil prices, the oil intensity of production - the quantity of oil used to achieve a given output - is also much lower. If oil prices remain high it will continue to fall.
And this time around, unlike the '70s, the rise in oil prices does not come in an environment of rising world inflation and widespread wage pressures and wage indexation. Other explanations include a temporary spur to prices from the activity of speculators, including hedge funds.
All of these factors help explain the very different response to high oil prices now and the relatively relaxed view of central bankers.
What happens from here? This is where Galbraith's dictum comes into play. It is not hard to find forecasts from reputable sources that have a steady rise in the oil price, a plateauing at or below present levels, or a sharp fall.
History suggests it will fluctuate, probably sharply, although perhaps not as sharply as in the past because producers are more sensitive to the danger of an oil glut.
But one thing is certain: the world will not run out of oil.
Along with natural gas it will remain a prime energy source for a long time, but it will be a declining one as technology delivers more efficient use of oil and develops alternative fuel sources. As former Saudi Arabian oil minister Sheik Ahmed Zaki Yamani famously observed, in one of my favourite epigrams: "The Stone Age didn't end because the world ran out of stones."
