Apart from England’s football manager Kevin Keegan reviving his permed hair, what worries most people about a 70s revival is the prospect of the Organisation of Petroleum Producing Countries (Opec) holding western economies to ransom over oil prices and supply. The 1973–74 spike in prices provoked a global recession, but does the resurgence in crude prices mean we are in for a re-run?
Analysts fell into two camps towards the end of last year. Some believed many economies could not survive the shift up in the barrel price from around $10 to touching $30 between 1998 and 2000, the highest seen since the Gulf War. Others suggested that in real terms oil was still cheap, and the long-term average curve showed they were not off the mean.
The price has been sustained over the past two years by two things: first, the global recovery from the slump caused by the crisis in the markets in 1997 and 1998 has fed demand. Second, Opec’s restraints on output introduced a year ago, cutting daily production by around 4m barrels, have had the desired effect on prices. The restrictions led to a gap of around 2m barrels a day gap between supply and demand. With Opec likely to increase supplies over the next 12 months, will that gap close and what does this mean for prices?
Monika Rosen, Bank Austria’s head of research in Vienna, believes the markets have already priced in Opec’s long-trailed increase in output. “We may see a slight correction, and the news will doubtless lead to improved inflation figures. Also the timing is important, as the second quarter of the year is traditionally a weak one for the sector, coming at the end of the north European winter, and before the driving holidays of the summer. Consequently I suspect we will see a weakening of the sector to come.”
The problem for Opec is how to maintain a higher price for crude, and hence increase the revenues paid to its members, without tipping the world economy into decline, and thus slashing demand for its product. There will inevitably be pressure from some countries that need to repair infrastructures, such as Venezuela, but this will be balanced by diplomatic pressure from manufacturing countries fearing the spectre of inflation. Interestingly, although oil prices are often cited as key indicators for inflation levels, the tripling of the price of crude has not had a disastrous impact. One important reason for this is the greater awareness of energy conservation, in both industry and the home, a side-effect of the 1970s crisis. Another reason may be that, in a more competitive world, factory gate prices cannot be hiked to offset raw material costs – instead, manufacturers take a hit to their profit margins.
Mike Young, chief European strategist at Goldman Sachs, says the price hikes have had a significant effect in retail levels in Europe, although not as much as in North America due to the higher tax proportion. “In Italy, for example, we have seen the government suggesting a lowering of taxes as a way of reducing the impact of higher oil prices on inflation. Price indices indicate that a key accelerator has been oil prices. We have, however, seen strong deflationary trends. One was the deregulation of the German electricity sector, which caused power prices to fall, even in the face of increases in the basic price of gas and energy and other inputs into that segment rising, causing a real collapse in margins and earnings there.”
Young sees a wider evidence of price competition precipitated at consumer level by the internet. This, he claims, has made the entire household sector more sensitive, which prevents retailers passing on any increase from rising energy prices. “What we are looking at is the adding up of a strong cyclical push to costs going up through energy prices and an increase in wages, against productivity gains which the recovering economy is allowing in Europe, and the secular deflationary impact of deregulation, and increased price transparency which the internet has brought,” he says.
The spate of consolidation represented by mergers and takeovers across Europe and North America have not been affected by the price of crude. This is a clear sign that the industry believes this is the right policy, and if it still makes sense at $30 a barrel, then we are likely to see more of the same helping to prop-up share prices.
Once again the question of increased competition within the sector, and how to generate earnings in that environment in the face of increased prices, has to be tackled. Young says that in a world where there is such stiff pricing competition, scale becomes an important issue. “If companies cannot increase earnings by increasing margins, you make them go up by increasing scale to produce more efficient operations. In some areas it is thought there is a limit to this, but again new technology comes into play. It has increased command and control, sales flow can be viewed daily and globally, and risk can be evaluated worldwide. Thus scale can temporarily increase margins, and perhaps continue to do so, by combining reduced unit costs with the ability to capture some of the savings.” Kevin Hall