Oil panic pushes up risks

Economy can adjust to oil at $50, or even $80, a barrel but the transition would be risky.

By Edward Hadas, Breakingviews

LONDON (Breakingviews) – The price of oil keeps rising.

That means three things: First, there will be calls for greater energy efficiency. Second, the balance of interest rates and growth rates looks even more fragile. And third, a sharp fall in oil prices is more likely.

Let’s look back to the 1970s, when oil prices tripled. The smart money was on the end of industrial civilization as we knew it. Now that the Arab world had recognized its power oil prices would only go up, leading to all sorts of problems.

The smart money was mostly wrong. Higher oil prices provoked big increases in energy efficiency and oil exploration. The net result was two decades of unexpectedly cheap energy.

The pessimists, however, did get some things right. The shift of money from efficient, rich oil-consuming countries into inefficient, poor oil producers caused problems. The growth pain was minor — a few percentage points lost over a few years– but the financial pain was tremendous. Oil-spurred inflation crushed bond returns and helped provoke a ten-year bear market for equities.

This time might be different, but don’t count on it.

Industrialists are just starting to believe that oil prices will stay high, but they are already talking about how to make the world less oil dependent. It starts with selling fewer SUVs and moves on to the revival of nuclear power.

And oil companies such as Shell are starting to think about sharp increases in exploration and development expenses. Much of the industry is holding back, but if prices stay high the old plans for coal gasification and oil shale extraction will surely start coming out of the file cabinets.

As for the global financial balance, it was looking pretty precarious before the oil disruption. The oil price boom does not help. The cost of imported oil is making the huge U.S. deficits even more disruptive.

Further, the effort to keep up demand through easy money in the U.S. and Europe increases the risks of higher inflation. And if the cost of oil hits profits, equity prices could suffer.

Yet as the oil price rises higher, a sharp fall becomes more likely. After all, prices do affect demand; there are already hints of a Chinese slowdown.

A small shift in the fundamental balance could lead to a big change in speculative positions which could pummel oil prices. The 2004 oil boom might yet prove brief.

Breakingviews is Europe’s leading financial commentary and analysis service. Its team of financial journalists comments on the most important financial stories of the day, as they break.

Find this article at:
http://money.cnn.com/2004/10/12/commentary/breakingviews/bviews_hadas/index.htm