Business Analysis: Oil rises to the top of the G10 agenda after fresh spurt in price of a barrel

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The Independent Online

The surge in oil prices emerged yesterday as central bankers' public enemy number one in their fight to keep the recovery in the world economy on track.

As the cost of crude oil hit a fresh record above $60 a barrel for the third successive day, a meeting of bank governors of the Group of Ten (G10) nations struck a gloomy note.

Prices hit records on both sides of the Atlantic, as Iran's new hardline leader took a hostile stance towards foreign investment in its oil industry. Mahmoud Ahmadinejad appeared to rule out improved ties with the US and called for a greater focus on domestic players in the country's oil industry.

Nout Wellink, a member of the European Central Bank and president of the Bank of International Settlements (BIS), which hosted the G10, said high oil prices were "dampening" growth in many regions of the world.

Bill White, who heads BIS's monetary and economic department, said the "real worry" was high oil prices slamming the brake on consumer spending in some countries.

"There is at least a risk, if not measurable risk, that there could be repercussions associated from oil prices that might be greater than the consensus [forecasts] expect."

Stock markets, which had appeared to ignore the threat to profits to scale new highs, finally responded last week to growing concerns over the impact to growth.

The Dow Jones index of leading American companies fell by more than 3 per cent last week. Yesterday the FTSE 100 followed Friday's 35-point fall with a further 35-point drop.

The bankers' warning will come as little surprise to the man or woman in the street. Petrol prices have risen to a record 86p a litre - or £3.91 a gallon for those with longer memories.

Road hauliers could soon be paying £1 for a litre of diesel - well above the levels that triggered the fuel protests that brought the country to a virtual standstill in the autumn of 2000.

Meanwhile, holidaymakers travelling with British Airways and Virgin Atlantic face an increase in air fares of about £8 a ticket.

Oil prices feed though to the wider economy in many ways, which is why many economists believe all recent recessions can be explained by a surge in oil prices. They impose a tax on businesses by raising their raw materials bill. At the other end of the supply chain, they sap consumers' demand by eating into their disposable income.

Meanwhile, it can harm the macroeconomic outlook if the increase in prices feeds through into higher inflation, which in turn forces central banks to raise interest rates even as growth is slowing.

Think back to 1975, when the oil producers' cartel Opec delivered a major shock to the economy when it imposed an embargo in retaliation for the Arab-Israeli war.

The resulting cocktail of recession and inflation - which led to the invention of the ugly word "stagflation" - took several years to fully flow through.

Fast forward three decades and the surprising thing is that there is no sign of a repeat. Mervyn King, the Governor of the Bank of England, slapped down one journalist who suggested the world was heading for stagflation.

"If you mean a return to what was called stagflation in the past, then I think you really ought to get a new dictionary," he said. "The central projection that we have got is for growth to remain close to trend and for inflation to remain close to the target. That is about as far away from stagflation as you can possibly get."

That pattern is repeated across the world, with inflation remaining constrained and growth still strong despite the recent dramatic increases in prices.

As the BIS points out in its annual report published yesterday: "Compared to earlier episodes of sharply rising commodity prices, the impact on global activity and inflation has been relatively mild. One factor is the greater energy efficiency of advanced industrial economies - the oil intensity of [rich] countries is now about half of that in the 1970s."

There are other factors - lessons have been learnt from the 1970s, globalisation has allowed companies to be more astute in their sourcing, while for Western consumers falling goods prices and rising incomes have masked the wealth effect of oil.

The implication of that analysis, however, is that the level of oil prices at which the pain really starts to be felt is simply much higher. As the BIS acknowledges: "Oil prices will remain high for a prolonged period of time. Further rises - if they materialise - may have more severe consequences than currently anticipated."

It certainly looks as if we should brace ourselves for higher prices. Analysis of prices for oil to be delivered in December shows the probability of oil being above $75 a barrel at the end of the year has risen from 5 per cent in January to almost one in four now.

"The top risks are all skewed to the upside," said Michael Lewis, the global head of commodities research at Deutsche Bank. "We have strong demand in China, political chaos in Russia, the situation in Iran, ongoing problems in Iraq. On top of this there are risks of another severe hurricane season in the Americas, which caused such problems last year, and the possibility of a cold winter."

Meanwhile, current benign weather is constricting wind and hydroelectric power sources and threatening to curb the output of nuclear stations that cannot operate without cool water.

Furthermore, the industry has failed to invest in refining capacity to cope with strong demand, allowing speculators to have a field day. "Unless there is a sharp downturn in global growth, at this stage it is difficult to see what will break the cycle," Mr Lewis said.

In the past, one-off shocks such as war or political turmoil caused a shock of sufficient magnitude to bring the world to its knees and dry up demand for oil. This time prices have reached $60 without any dramatic news.

Mr Lewis said this meant Western governments would be unwilling to dip into strategic reserves that are usually conserved to deal with shock events.

Opec is reported to be preparing another increase in supply even though traders ignored their decision in June to raise supply, since when prices have risen $5 a barrel.

Analysts and central bankers are looking for signs of weakening demand. Last month the key ISM survey of US factories showed a sharp slowdown in growth and economists are awaiting the next report on Friday.

The issue is likely to be near the top of the G8 meetings in Scotland next week, according to German sources - although the UK appeared keen to play down hopes of a substantial breakthrough. A spokesman said: "Leaders will discuss issues of importance to the global economic situation. They may, of course, pick up on the oil issues highlighted by finance ministers when they met in London in June."

Perhaps one reason for the low-key approach is that Gerhard Schröder, the German Chancellor, is planning to call for a controversial clampdown on oil price speculators.