Mark John and Sarah McFarlane

LONDON (Reuters – Although the world is less dependent upon oil today than during the shocks that hit the 1970s energy markets, the Ukraine crisis shows the stubborn need for oil. It can disrupt countries, confuse policymakers, and cause political turmoil.

    When the Yom Kippur War of 1973 triggered an Arab State oil embargo that convulsed world markets and sent inflation into double-digits, oil made up nearly half the global energy mix – a figure that has since dropped to around one third.

    The shift came as rich countries focused more on services, factories became more efficient and electricity generation switched away from using oil to coal and instead.

    A Columbia University study last year found that the same economic growth which half a century ago required one barrel of oil could now be had with less than half a barrel.

    Some analysts had in recent years even speculated that the world economy could take future oil shocks in its stride. Others pointed to the COVID-19 lockdowns of the past two years as evidence that the economy could – in an albeit different form –  function with dramatically lower oil consumption.

    But the roaring back of oil demand in 2021 and the spike in oil prices triggered by the Ukraine conflict has highlighted again the size of the effort that will be needed to wean the global economy from an oil habit ingrained over decades.

    Shifting oil demand is difficult in the short term as it requires trillions of dollars to replace legacy infrastructure such as vehicles and equipment, said Alan Gelder, VP refining, chemicals, and oil markets at consultancy Wood Mackenzie.

He stated that investment is necessary to decrease the correlation between economic activity and oil consumption.

    The latest rally in oil prices – up 50% since the start of the year – has buried the hopes nurtured last year by the world’s central banks that the inflation stoked by pandemic-era stimulus packages would be “transitory”.

    Instead it has made it only too clear just how deeply oil permeates the internal mechanics of the global economy.

PETROL POMP ANGER

Americans drive less, and the fares charged by airlines for flights are higher. Derivatives account for a large part of all the increased prices consumers pay now to purchase essential goods.

Graphic: Oil and inflation expectations: https://fingfx.thomsonreuters.com/gfx/mkt/byvrjbrjrve/Pasted%20image%201648127138669.png

    In the United States, the Fed estimates that every $10 per barrel rise in oil prices cuts GDP growth by 0.1 percentage point and increases inflation by 0.2 percentage point. According to research by the European Central Bank, a 10% increase in oil prices in euros terms will cause inflation to rise by 0.1% to 0.2% in the euro area.

    Inevitably, that most visible impact is at the petrol pump.

    Europe’s oil-importing nations are racing to offer motorists fuel rebates and other concessions, mindful of how their anger can spill over into wider protest – as it did with the “yellow vest” movement in France back in 2018.

    Asia, as the region with not only the world’s largest demand for oil but also the fastest growth in demand, is also badly hit. Japan and South Korea, which are increasing fuel subsidies to compensate for higher prices, are two examples.

    The world’s biggest oil producer, the United States, should be better shielded than others. Jerome Powell, the Chair of the Federal Reserve noted Monday that the United States is better equipped to handle an oil shock today than it was in 1970.

    But that did not stop him from delivering his strongest message to date on his battle with too-high inflation, suggesting the central bank could move “more aggressively” to keep an upward price spiral from getting entrenched.

KICK A COSTLY HABIT

    If it took five decades for oil’s share in the global energy mix to fall from 45% to 31%, it remains an open question how quickly the world – now with its avowed goal of net-zero carbon economies – can further reduce that share.

    Motorists’ switch to electric vehicles is expected to cause a tipping point in global oil demand, sending it into decline. The largest sector that uses oil is passenger vehicles, which consumes around 25% of all oil worldwide.

    “Oil intensity will from now on fall much faster, as global oil demand will peak within the next few years, thereafter to decline, while GDP will continue to grow,” said Sverre Alvik, energy transition programme director at energy adviser DNV, which sees electric vehicles reaching 50% of new passenger vehicle sales in 10 years.

    Yet that is only one side of the story.

A large amount of oil demand remains stable due to the rising oil prices in Asia and the fact that many key industries like shipping, aviation and freight are still relying on oil for their fuel needs.

    “Our projections suggest that dependence on oil, particularly imported oil, is unlikely to disappear quickly,” IEA analysts concluded in a 2019 note entitled “The world can’t afford to relax about oil security”.

    Such outlooks suggest that, even in a best-case scenario, the world’s transition from oil and other fossil fuel sources will pose new challenges for consumers and policymakers alike.

    European Central Bank Executive Board member Isabel Schnabel this month used the term “fossil-flation” for the price to be paid for what she called “the legacy cost of the dependency on fossil energy sources”.

Schnabel believes that this cost is partly due to the fact that policies such as carbon pricing increase fossil fuel prices, but also because energy producers have the ability to create artificially tight markets in order for them push up import prices at the expense and consumers.

Add to this the US and British embargoes on Russian oil, along with Europe’s goal to cut its Russian gas imports. She concluded that a marked drop in fossil energy prices as shown by futures prices seems unlikely.