London, 18 January 2011

Past experience suggests oil prices are at a level that poses a serious threat to the advanced economies and increases the risk of a double-dip recession. The International Energy Agency (IEA) has warned prices are approaching the "danger zone". Total's bullish Chief Executive Christophe De Margerie has admitted "it would have been better for the prices not to go too high too quickly".

But OPEC members are resisting calls for an emergency meeting or output increase. Price hawks Iran, Venezuela and Libya have indicated they are comfortable with $100. Even the more moderate Saudi Arabia seems unwilling to try to restrain prices by upping production despite reaffirming its commitment to a notional price target of $70-80 per barrel.

2007-2008 TIMELINE

What level of oil prices actually damages growth is an empirical question. Oil bulls dispute the claim high oil prices played any significant role triggering the last downturn, or pose a serious risk to growth in 2011. In particular, they note economic output in the OECD is now far less oil-intensive than in the 1970s and early 1980s, reducing the risk of sharp price rises causing a macro shock.

For the bulls, falling U.S. house prices, an escalating credit crisis, and the lagged effect of interest rate increases by the Federal Reserve and other central banks between 2004 and 2007 are sufficient to explain the start of the Great Recession in 2007-2008.

Surging oil prices played little or no role despite doubling to $140 in the twelve months to July 2008, a record level in both nominal and real terms. Oil bulls argue prices would have been sustainable above $100 if the recession had not intervened. Prices were driven by macroeconomic factors, not the other way around. The seizing up of global credit markets following the collapse of Lehman Brothers followed by the sudden collapse of trade flows and industrial production triggered the sharp fall in crude oil prices in late 2008.

Using current econometric techniques it is not possible to disentangle the effect of rising oil prices from the impact of a slowing housing market, interest rate rises and mounting financial problems in the banking system. But it is clear industrial production had peaked in most of the advanced economies well before Lehman imploded in September 2008 -- a time when rising oil prices were hitting consumer spending and raising business costs.

Industrial output peaked in Italy, Spain and the United States as early as June-August 2007, according to official estimates published by the OECD. This is consistent with the findings of the U.S. National Bureau of Economic Research (NBER) which date the onset of the recession to December 2007.

Twelve other OECD members saw production peak between December 2007 and June 2008 -- including the Netherlands and Sweden (Dec 2007); Finland and Mexico (Jan 2008); Germany, Hungary, Japan and Slovakia (Feb 2008); and Belgium, the Czech Republic, France and Greece (Apr 2008). The global recession was well underway six months before Lehman went bankrupt (though of course it intensified afterwards). U.S. equities peaked in late 2007 and had slid substantially by the time oil peaked in July 2008, let alone the seizure of credit markets in September 2008.

COMPLACENCY RISK

Of course problems with subprime loans had started to become more visible from summer 2007 onward. The first disturbing tremors of the credit crisis were felt in August 2007. Investors started to become much more cautious and risk premiums rose. But few at that time foresaw the extent of the crisis that would eventually unfold. Even the Fed thought mortgage problems would be largely "contained".

With current techniques it will never be possible to determine the precise role of rising oil prices compared with other factors in tipping the U.S. and other economies into recession in H2 2007 and H1 2008. But it should be clear these economies were already starting to look very unhealthy as oil prices begin their final ascent from $50 at the start of 2007 to $147 in July 2008.

We do know increasing expenditure on oil and other forms of energy began to drag on other forms of consumer spending in this period. We also know the full impact of price rises only becomes apparent over time as higher costs sap household and corporate budgets and begin to filter through to other price increases. It is therefore highly likely rising prices were exerting a negative influence on the economy well before they peaked at $147 in July.

Bullish observers dismiss these concerns by pointing to continued strong growth in emerging markets, which they expect to continue supporting rapid increases in oil consumption. But emerging markets are not immune to price rises either. In fact, unlike the advanced economies, emerging market growth is very oil intensive, leaving them far more exposed to the damaging effects of price increases. Moreover, emerging markets still rely to a significant extent on exporting to the OECD and are exposed to any renewed slowdown.

No one can quantify the effects of rising oil prices on global growth precisely or separate them from the impact of monetary policy, financial conditions and confidence. But sharp oil price increases have been associated with downturn in the past, and the last time oil prices were at this level the OECD economies had already started to slide into recession.

It is dangerously complacent to assume prices can remain at present very high levels, or continue rising, without becoming a drag on growth in 2011 and increasing the risk of a renewed downturn.

Ends --

By John Kemp, Reuters market analyst – for Commodities Now.

The views expressed are his own.