Oil shock

Photo / NZ Herald

With oil prices up around 23 per cent since the start of the year and a mounting risk that the wave of unrest sweeping the Arab world will engulf the Gulf, concern is growing that the economy will be sideswiped by an oil shock.

Today's day of rage in Saudi Arabia and similar protests called for in Kuwait, Bahrain and Yemen may give an indication of where in the geopolitical gauge between serenity and dread the needle is pointing.

Saudi Arabia is the oil industry's swing producer with the greatest ability to increase production to offset lost supply elsewhere. If it switched from being a stabilising influence to a seat of instability the impact on oil prices is likely to be ugly.

So what are the ways higher oil prices would affect the economy?

Inflation is the most obvious. Vehicle fuels make up 5.8 per cent of the consumers price index, which reflects what the average household spends money on. Most of that, 5.4 per cent, is petrol prices, which have climbed 9 per cent since the start of the year.

That understates the impact, however. New Zealand consumes almost as much diesel as petrol, so there is also the added cost of trucking goods around.

Diesel has gone up 19 per cent since the start of the year. It is more affected by the loss of Libyan supplies as Libya produces a high-grade crude oil particularly rich in diesel.

But there is an offsetting effect on inflation, says the New Zealand Institute of Economic Research's principal economist, Shamubeel Eaqub.

Higher prices for necessities like fuel and food tend to crowd out spending on discretionary items. For example spending last month paid for on electronic cards was up 10 per cent on a year earlier for food and fuel but just 3 per cent for everything else.

Higher fuel prices act like a tax , reducing consumption overall and reducing the ability of firms chasing the consumer's discretionary dollar to raise their prices.

In the context of an economy that has been going sideways for the past year and where the unemployment rate is 6.8 per cent, firms' pricing power is weak and so is employees' wage bargaining power. So higher fuel prices are likely to mean lower profit margins and lower real wages. The risk of persistent 1970s-style inflation perpetuated by wage-price spirals should be correspondingly lower too.

But BNZ chief economist Tony Alexander cautions that after three tough years margins have already been squeezed hard.

An oil shock would also be bad for business investment not just because of its immediate impact on profitability but because it would be accompanied by a level of uncertainty about the global and national economy likely to deter any spending deemed non-essential.

"In 2008 consumer and business confidence fell very sharply as oil prices rose. And this time, we have already had the earthquake and there is the spectre of rising food prices too," Eaqub said.

The big swings in international oil prices in 2008 are instructive. They Concern rising at risk of oil shock to economy

5.8 per centThe amount that vehicle fuels make up of the consumers price indexfell from nearly US$150 a barrel to below US$40 within a few months as fears arose of another Great Depression.

As it turned out the actual drop in oil consumption in 2009 was only about 2 per cent but the prospect of lower demand, in the context of enough fear and uncertainty, had by then delivered a 70 per cent peak-to-trough fall in the price. The risk is that it works the same way in the other direction when the fear is on the supply side, even if little or no disruption to supply eventuates.

In such a context risk appetite in global financial markets generally could fall rapidly, warns Eaqub, with unpleasant implications for the cost of borrowing.

He is less concerned that sharply higher oil prices would derail that locomotive of global growth, the Chinese economy. "China has a tendency to smooth things out for its consumers in terms of subsidies."

Alexander said it was important that higher fuel prices be allowed to flow through so that people would respond to the price signal by investing in more energy-efficient technology in vehicles, production processes or whatever.

"I don't know where the petrol price goes in the next couple of years [but] it is going higher and you would want to factor that into your plans."

Over a barrel

Gauging global oil prices can be confusing, because there are three main benchmarks. These are:

West Texas crude

* A "sweet" crude containing only about 0.24 per cent sulphur.

* Sourced in Texas and Oklahoma and mostly refined in the Midwest and Gulf Coast regions of the United States.

Brent crude

* Also a "sweet" crude, containing 0.37 per cent sulphur.

* Sourced from 15 different oil fields beneath the North Sea, in northern Europe, and usually refined in Europe.

Dubai crude

* A "sour" crude containing 2 per cent sulphur.

* Sourced in Dubai.

* Mostly exported and refined outside the United Arab Emirates.

Which is best?

Energy analyst Richard Hale of Hale & Twomey said all three were important benchmarks for oil prices, but Brent was the best reflection of the global crude price at the moment.

Brent for April delivery was trading at around US$115.50 a barrel on the ICE futures exchange yesterday, while West Texas was selling at US$102.79 per barrel on the NYMEX.

Hale said Dubai crude was the most important marker for New Zealand.

"About 60 per cent of the crude that is run through the refinery at Whangarei [Marsden Point] is Dubai related," he said. Dubai crude was at US$110.35 yesterday.

brian.fallow@nzherald.co.nz