I. Background to the Price Surge and Its Outlook

1. Supply and Demand

Since the 1970s, there have been three oil crises, taking place in 1973/74, 1979/80 and 1990/91. In the first case, oil prices surpassed USD10 (per barrel, same as below). In the latter two occasions, oil prices peaked around USD40 and currently we saw the same level of prices again, with crude oil futures rising above the peak in the autumn of 1990. In these three occasions, political reasons that affected the supply of oil formed the major propelling factor that boosted oil prices. For example, the embargo after the Israeli-Arab war pushed oil prices sharply higher in 1973/74. The Iranian revolution and the subsequent war between Iran and Iraq during 1979/80 and Iraqi invasion of Kuwait both fuelled oil price rise.

Currently, we can also see political factors affecting oil supply. Firstly, there seem to be few signs that unrest in Iraq would gradually mitigate in the short-term. Under such situation, full production would probably be impossible in the near future, not to speak of developing further oil reserves. Secondly, oil facilities of Saudi Arabia were attacked by terrorists. Since the country is the largest oil supplier and possesses the largest spare capacity, the market has been particularly nervous. Thirdly, the current spare capacity of OPEC is only 3% of global demand, much lower than the 9% recorded around 1991. Furthermore, domestic strikes in Nigeria and Venezuela also hurt supplies in these countries.

In addition to the above supply situation, stock of oil has also been relatively low in western countries. Statistics from the IEA indicate that current stocks of OECD, though rather stable, are much lower than that of the 1990s. Moreover, U.S. policy has also shifted to accumulate oil reserves despite high prices recently, instead of releasing stocks of strategic oil reserves as in the past. These would also add upward pressure on oil prices.

Nevertheless, the impact on actual oil supply in the current situation has been much limited compared with the past. Though Iraq remained unable to resume full-scale production, IEA estimates indicate that Iraq's recent output of 2.34 million barrels (daily, same as below) does not fall much behind of the pre-war level of around 2.5 million. Besides, there has also been no indication of serious supply disruption in Nigeria and Venezuela. As for the low reserve situation and the potential threat to oil supply, there has been no material impact on actual supply from these factors. Therefore, oil supply problem in the current price hike has been mainly a matter of "intensified concern for supply" so far.

At the same time, demand played a more crucial role compared to the past. IEA estimates that global oil demand would set a 16-year record high in 2004, reaching 80.6 million barrels. According to the estimates, demand in the fourth quarter would even exceed supply.

Going through the oil demand statistics, it can be seen that demand from western countries grew moderately by an average annual rate of 0.6% during 2000-2004 (IEA estimates for 2004). Demand from developing or newly industrialised countries in Asia experienced more substantial growth, on the other hand, and formed the major impetus to global demand. IEA statistics indicate that the average annual growth of oil demand from non-OECD Asia is 4.8% during 2000-2004. China, India and South Korea are the major countries within the group, with demand from China surging at a remarkable pace of 7.7% during the period. Nonetheless, being a developing country, China's relatively higher demand growth should be regarded as normal. Comparing the actual growth of China's demand during the four years of 1.6 million barrels with the OECD's 1.2 million, the difference is not that great. It should also be noted that according to the 2004 estimates, China's demand only accounts for 7.7% of the global total, still much less than the OECD's 60.8% and OECD North America's 31%.

2. OPEC's attitude

In recent years, the OPEC has set the reference range of oil prices within USD22-28. Nevertheless, since late last year the organization has trimmed output amid rising prices even above the upper limit. OPEC's recent discussion about lifting output also came up with mixed opinions. However, the experience of increasing output before the 1997 financial crisis had added to the OPEC's cautiousness in output decisions. Prices then went down to as low as USD10. There are also reports about some members' desire to boost the target price up to USD34 amid the weakness of the USD in recent years. As OPEC has been increasing imports from the Euroland, such intention should be easily understood.

3. Speculative forces

According to information from an energy consultancy in the U.S., the impact of speculative forces in the current oil price surge should not be overlooked. It is estimated that by the end of April 2004, total contract value of crude oil futures has reached USD26 billion, being 2.17 times of the value recorded a year ago. In fact, most factors mentioned above would encourage speculation, including the tighter gap between demand and supply, the potential threat to supply and the relatively slim stock levels.

4. Oil prices in the near-term

In short, demand factor plays a larger role in the current price hike compared with the past while there has not been serious disruption to supply comparable with the past crises. Speculative activities also intensify. Yet, it is difficult to identify the individual factor's impact on the prices.

Currently, OPEC would probably be cooperative in boosting output, even though members intend to raise the target range of prices. Since high oil prices would likely pose adverse impact on Bush during the U.S. Presidential Election later in the year, further pressure on oil producers to boost output can be expected. In fact, western countries have already come up with the consent to request for increase in oil output, as stated during the recent G7 meeting.

Turning to the economic development prospects within the year, interest rate hike would probably commence in the U.S. Mild inflation, together with the Presidential Election by the end of the year, would probably restrain the magnitude of interest rate rise this year (likely to be 50-75bp). Yet, it would fuel expectations of further rate hike in the coming year. U.S. short-term interest rates are now forecasted to peak at around 3-4%, implying the overall rate hike would be as much as 300bp. This would lead to expectations of gradual slowdown of the U.S. economy, thus limiting the upward momentum of oil prices. In addition, China has commenced her delicate macro-control measures and this would probably restrain oil demand growth.

The major uncertainty should be the threat of terrorist attacks. Should such threat not intensify, speculative activities would retreat and oil prices should gradually decline from the current high levels. Nevertheless, since it is almost impossible to disregard such risk, and also taking into consideration the relatively tense demand and supply situation, it is estimated that oil prices would still remain on relatively high levels by the fourth quarter at USD30-35 per barrel.

II. Economic and Financial Trends amid High Oil Prices

Rising oil prices would certainly pose adverse impacts on the economy. The three crises were all followed by economic recessions. Nevertheless, it should be noted that though oil prices have exceeded the peak of 1990, discounting inflation, today's oil prices are only around 40% of those in 1980 (that means prices then counted today should be around USD95 per barrel). Therefore, the current adverse impact on the economy should be much less severe. When taking into consideration the impact of inflation, oil prices only peaked around USD50 during 1990/91. Since the U.S. economy in 1990/91 was also affected by the banking crisis, the role that high oil prices played in economic recession had already been less significant.

Since the outbreak of oil crisis in the 1970s, western countries have been gradually reducing their reliance on oil. Among the three major economies, ie. U.S., Japan and Germany, the growth of oil consumption of the first two between 1980 and 2002 were only 16% and 7% respectively, while Germany even registered a decline of 12%. In the OECD, the ratio of oil imports also fell from 13% during late 1970s to around 4% in late 1990s. Recent assessments of impacts of high oil prices by major institutions have rarely come up with a "recession" conclusion. IEA has estimated that global economic growth would only increase by 0.5 percentage point should oil price remained at USD25 in the past two years. According to the IMF, if oil prices grew by USD5 on average each year above its baseline forecasts, global economic growth would only decline by 0.3 percentage point.

High oil prices would certainly affect inflation. Recently, energy prices have already contributed to the moderate rise in U.S. prices. Nevertheless, the Federal Reserve would probably not tighten credit more aggressively should energy prices form the single force in price increase. Should high oil prices lead to U.S. or even global economic slowdown, the Fed is likely to be accommodative, creating a pro-growth environment. As for the European Central Bank, it has been stricter in observing the price stability objective. Recently, the Bundesbank Chief suggested a more accommodative attitude towards high oil prices. Actual practice of the ECB, however, remains to be seen.

For Asian countries that experience higher oil demand in recent years, high oil prices would certainly be more unwelcome. China has already become a net oil importer. Net imports of oil would exceed 100 million tons this year, according to estimates. High oil prices would certainly eat into her trade surplus and hence trim economic growth. Amid macro-control measures currently implemented, high oil prices would add to the cooling impact on the economy. Whether this would lead to over-cooling is difficult to estimate. Adjustments in official policies also count.

As for Hong Kong, past oil crises did bring about negative impacts to the economy. Persistently high oil prices in this occasion would certainly be no exception. The SAR has been an importer of oil products. Domestic consumption would soften amid rising energy and transport costs. Hong Kong's external trade would also be affected, as the international economy suffers from high oil prices. Compared with the advanced economies, Hong Kong would be hurt to a larger extent, as China would be more significantly affected. Hong Kong would also recover from deflation earlier. Yet, the originally expected positive impact would not turn up.

Considering international capital flows, high oil prices would be mostly unfavorable for Asian currencies. China's macro-control measures have already dented capital inflows. High oil prices would further remove currency appreciation pressure. In the global forex market, the US dollar would probably benefit most with the U.S. economy among the least affected. The Japanese Yen would suffer. As for the Euro, in view of increasing imports from the Euroland by oil exporting countries, pressure on the currency can be much released.

Chan Wai Sum
Economist