High oil prices are fuelling inflation, adding to the risks facing the global
economy. At the same time, oil demand is sensitive to economic growth as
transport fuels are now the main driver.
Rising oil prices threaten both oil demand and the global economy. With Brent crude nearing the $100/bl barrier, oil prices are close to their inflation-adjusted 1980 peak after the 1979 Iranian revolution that triggered a worldwide recession and a prolonged slump in oil consumption. A repeat performance is unlikely, since the global economy is less dependent on oil and central bankers are much better at managing inflation. But high oil prices are starting to cause a strain.
Inflation rates are rising globally as competition for food, energy and raw materials drives prices up. Oil is not the only commodity to experience sharp price rises over the past few years as growing demand from China and India strains production capacity. But oil remains an important component of inflation in a globalised economy that depends heavily on transport. And rising demand for transport is driving up food prices as more land is turned over to the production of biofuels, reinforcing inflationary pressures.
Making enough transportation fuel is the biggest challenge facing the oil industry at the moment. Despite rising oil prices, demand for transport fuels — gasoline, diesel, jet fuel and marine bunker fuel — continues to grow strongly, fuelled by the booming global economy. Over the past four years, transport fuel demand in the 14 oil-consuming economies monitored by Argus Fundamentals grew at an annual average rate of 2.5pc — about half the rate of growth of the global economy (see top graph p2). But refiners are struggling to keep pace with the growth in transport fuel demand, adding to the upward pressure on oil prices.
High oil prices are already depressing demand for oil as a burning fuel. Demand for oil in heating and power generation in the same group of countries has fallen at an annual average rate of nearly 6pc over the past four years as consumers switched to cheaper alternative fuels, such as coal and natural gas. And this rate of decline doubled to over 12pc this year as oil prices surged to record levels. Some of this accelerated decline was because of milder weather last winter, but the continued downward trend since the winter suggests the demand loss is more permanent.
So far, continued strong growth in demand for oil as a transport fuel — together with other non-combustion uses such as petrochemical feedstocks, bitumen and lubricants — has outweighed rapid decline in demand for oil as a burning fuel, ensuring that oil demand as a whole continues to grow. Global oil demand rose by 1mn b/d (1.2pc) in the first three quarters of this year from a year earlier, according to Argus estimates. But further growth cannot be guaranteed in the future. Transport fuel demand would slow if the global economy slowed. And with oil prices at their current high level, a rebound in burning fuel consumption looks far from likely.
The global economy is expected to slow next year but not go into recession. Central bankers have cut interest rates to help deal with the consequences of the US subprime mortgage lending crisis. But inflation is rising again — fuelled by higher oil and food prices — limiting the scope for further interest rate reductions. If oil prices continue to rise, there is a real risk that the economy will slow abruptly as central bankers act to contain inflation.
