The long-overdue retreat in crude oil prices may provide a welcome break for consumers. But it isn't enough to get oil's foot off the throat of the global economy, Julian Jessop argues.
Mr. Jessop, chief global economist at London-based Capital Economics, wrote in a research note this week that Brent crude – the North Sea crude grade that serves as a key global benchmark for oil pricing – remains at levels where, historically, the world's energy-intensive manufacturing sector stalls. This despite Brent's pullback in the past six weeks from nearly $120 (U.S.) a barrel to $108 – a consequence of global demand concerns as well as investor risk aversion amid the Cyprus banking crisis. (The North American benchmark grade, West Texas intermediate, also fell nearly $8 a barrel between the end of January and early March, but has since recovered almost half that decline.)
Mr. Jessop said recent history indicates that oil is a hindrance to manufacturing activity – and, by extension, economic recovery – whenever Brent is more than $100 a barrel.
"The global manufacturing PMI [purchasing managers index] fell below 50 in early 2008 when Brent first climbed above $100, and before the global crisis hit hard. The PMI also started to weaken in early 2011 when Brent rose above $100 again. Oil prices have been relatively stable above $100 for most of the last two years, but the recovery has been lacklustre throughout this period, too."
"High oil prices are themselves a major constraint on economic activity," he said. "Every $10 increase in the price of a barrel of crude represents a transfer equivalent to around 0.5 per cent of global income from oil consumers to oil producers."
While global GDP would be constrained by less than that – "oil producers will spend some of their windfall" – Mr. Jessop still estimated that a $10 rise in the oil price reduces global GDP by about 0.2 per cent.
"Oil prices rose by about $12 in just two months between early December and early February (sufficient to knock around 0.25 per cent from global GDP). It seems unlikely that it is entirely a coincidence that the recovery in the global manufacturing PMI has stalled again this year," he said. "Our view is that this is evidence of 'demand destruction,' where high oil prices undermine the global recovery and hence prove to be unsustainable. Either oil prices have to fall a lot further, or demand will need to find new momentum from another source."
But even if Brent crude retreated into the $90-$95 range – consistent with Capital Economics' forecast for the next two years – "we don't expect cheaper oil alone to provide enough of a boost to global demand to offset fiscal headwinds," he said.
"The cumulative fiscal tightening planned in advanced economies adds up to at least 2 per cent of their GDP over the next two to three years, or 1 per cent of global GDP," Mr. Jessop wrote. "To offset this … oil prices would have to slump by $50, taking Brent to $60. This is not inconceivable, but it is unlikely, providing another reason to expect the recovery to remain sluggish."