Facing up to the reality of a new oil crisis

This has happened so many times before that market professionals should be getting used to it. But they are getting younger and may need a backgrounder in economic history to appreciate market reality rather than unjustified optimism.

Let us turn the clock back. In 1980 crude oil prices shot up to $78 per barrel (adjusted to 2002 price levels) in the aftermath of the Iranian Revolution; a US recession followed. In 1990 oil prices hit $41 in the wake of Saddam Hussein's invasion of Kuwait; the US suffered an economic slowdown and the UK had its worst post-war recession.

Today industry experts see very little prospect of a fall in oil prices over the summer. The International Energy Agency says the demand for oil has risen by more than five per cent over the past year of which more than a third has come from the overheating Chinese economy.

The rest of excess demand is down to global economic recovery fuelled by very low US interest rates. On the supply side, there does appear to be a serious issue, despite official denials from Opec members.

Last week Russia signaled that it was now pumping oil at full capacity of 9.3 million barrels per day, and could manage no more. There was also a brief interruption to supplies in Iraq due to sabotage of a major oil pipeline. Meanwhile, refining capacity in the US is insufficient to meet current demand levels.

In such an environment the revelations about the abuse of Iraqi prisoners and the public relations fall-out, have helped to push world oil prices to a 21-year high. It is fair to point out that if adjusted for inflation, oil prices are less than they were 13 years ago, but we probably have not seen the 2004 highs yet.

The reason that oil crises quickly turn into economic recessions for the oil consumer nations is that higher oil prices lead to consumer and asset price inflation that has to be tackled with higher interest rates. The alternative of leaving inflation to spiral out of control would be even more damaging.

Now the higher oil prices go, the higher interest rates will have to rise to bring down inflation. And the higher interest rates go, the deeper will be the business slowdown or recession.

Equities and bonds, which tend to overshoot on the downside, could be in for a very rough ride indeed. Oil crises and stock market crashes go together like birds of a feather.

On the other hand, for the oil producer nations an era of high oil prices promises a once-in-a-generation economic boom, and a time of great prosperity. This is also a golden opportunity to reform and modernize economies in a painless fashion with plenty of money around to cushion the process of creating a more efficient economy.

However, the danger of bankrupting your customers can not be exaggerated. And oil producer nations would be advised to help their customers as far as possible.

But this particular oil price explosion looks a self-inflicted wound caused by a period of ultra-low US interest rates that has gone on longer than is prudent, and overheated the world economy. We can only watch as market forces take appropriate corrective action.