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Hetal Mehta, economist at Ernst & Young’s ITEM Club, explains that the modest upswing ITEM was predicting over the next couple of years in GDP growth is predicated on an oil price remaining below that of $100 per barrel.

If this increases to $120 or $150 a barrel in the long term this has serious implications for the strength of the wider economy.

“If it hits $200 per barrel as one Opec minister recently predicted then frankly all bets may well be off,” Mehta adds.

Impact across the whole economy

The research analyses how varying oil prices will impact on different economic indicators.

With oil prices climbing to $150 ITEM is forecasting that economic growth for 2009 would be trimmed from the current prediction of 1.5 per cent GDP growth to a weak 1.1 per cent.

The following year when many commentators including ITEM is currently predicting a strong recovery to 2.7 per cent GDP growth, high oil prices could cut that to below 2 per cent.

A long term $200 per barrel oil price would cut growth in 2009 to 0.9 per cent GDP growth and 1.2 per cent in 2010.

A higher oil price will have an impact across the whole economy. One of the main factors driving the predicted recovery in 2010 is increased consumption as high street spending picks up.

Public confidence

The ITEM analysis suggests, however, that with the oil price at $200 next year, consumption would turn negative and ensure only a modest improvement in 2010.

As Hetal points out the actual impact may be even worse. “Our predictions don’t take into account the impact on public confidence that this type of oil price increase would have and how that would feed back into the economy, so we may well be underestimating the potential downside,” he warns.

Similarly a modest recovery in UK manufacturing, which ITEM has recently said would cushion the worst of the pain from the downturn in the services sector, would be much weakened.

With the $200 per barrel scenario output growth in 2009 would be trimmed from a strong 2.5 per cent growth to 1.6 per cent whilst it would hit the wall in 2010 with a decline in output of 0.3 per cent.

Letter writing time

This analysis also poses some serious questions about keeping the lid on inflation.

As Mehta explains, “With oil permanently at $200pb The Governor of the Bank of England would be suffering from writers’ cramp with the number of letters he would have to write to the Chancellor explaining why the UK economy had breached the 2 per cent CPI target.”

ITEM predicts that the $200pb scenario could potentially nearly treble the headline inflation rate next year from just over 2 per cent to 5.9 per cent per annum.

“Whilst that is hardly a return to the rampant inflation of the 1970s and 1980s it would be a worrying trend after the tight control central banks have kept on inflation in recent years,” Mehta says.

Mismatch between supply and demand 

Oil prices have risen by about 400 per cent in the last seven years and 25 per cent in the first four months of 2008 alone.

ITEM claims that it is not unreasonable that they could continue to rise even at more moderate rates over the next few years. It believes that the factors driving this increase are not going to disappear over the next few years.

Mehta says that there is a major mismatch between supply and demand, whilst Opec members appear unwilling or unable to raise their output and the thirst for oil particularly in developing countries appears to be unquenchable.

“Throw in political concerns in the Gulf and in West Africa, the weak US dollar and a jittery market then you have a set of circumstances that only point to greater uncertainty and the potential for further oil price rises of the kind that we are basing our analysis on,” Mehta concludes.

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Related links

• Ernst & Young ITEM Club