Oil Prices

The sharp increase in oil prices recently raises questions about global financial stability. We should address these questions calmly and rationally.

The overall downside risk to global financial stability has distinctly increased as a result of the increase in crude oil prices, which actually began in the first half of 1999 but intensified in September this year to record a ten-year high of over US$35 per barrel.

What we are seeing, in essence is a manifestation of some, but not a large, imbalance between supply and demand in oil products, possibly brought about by a world economy that is more buoyant than expected. There has been continued rapid growth in the US, accelerating growth in the euro area, the first signs of recovery in Japan and a sharper than expected rebound in emerging markets, particularly in Asia.

But the decision by OPEC on 10 September to increase production by 800,000 barrels a day did not have any significant moderating effect on the price of crude oil and the matter has all of a sudden attained a political dimension. First in the euro area, where the problem has admittedly been made a lot worse because of currency weakness, there were blockades of main traffic routes. If repeated or intensified, they could risk seriously undermining the general economic recovery there. Then there is the renewed tension in the Gulf, and between Iraq and the developed oil importing countries, which has added momentum to the hike in oil prices in a rather nervous market.

So, notwithstanding the fact that most large oil importing countries are now less oil dependent and a lot more oil efficient than in the '70s, the perception is that the impact on inflation may be large enough to require a monetary policy response. At a time when equity prices are already considered to be too high and economic overheating a real possibility, an oil-induced monetary tightening, however skilfully it is carried out and explained, does not augur well for financial markets. Already we have seen quite sharp downward adjustments in stock markets world wide. If monetary tightening materialises to any significant degree, financial markets may be hit harder still, to the extent of risking the eruption of systemic problems somewhere.

It is of course difficult to second-guess central bankers' reactions to such unusual circumstances and inappropriate for a central banker to do so, but I do feel that there may have been a certain degree of over-reaction in financial markets, as there often is when they are presented with new uncertain factors. First, the imbalance between supply and demand in oil products overall does not seem to be that large, although analysts did point to the possibility of some shortage in the so-called "light and sweet" refined products in the winter months. But then this shortage should be a temporary one, as the effects of the significant increase in production by OPEC feed through to the refined products. Secondly, there is capacity in the developed economies (which are less oil dependent and more oil efficient than before) to absorb much of the increase in oil prices, given the continued rapid productivity growth and the much-improved fiscal position. Thirdly, central bankers are quite capable of looking through temporary phenomena, and some also have the wider mandate to take into account the possible adverse impact of their action on economic growth and the stability of the financial system in coming to a decision whether or not to tighten monetary policy. Fourthly, the use of strategic petroleum reserves in the US, whether or not politically motivated, should have some short-term dampening effect on oil prices.

The overall downside risk to global financial stability has indeed increased, but we should face it calmly and rationally.

Joseph Yam
28 September 2000

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