Are We Really Less Vulnerable To Oil Shocks?

By Stephen S. Poloz
April, 2003

The threat of war has kept oil prices above $30 for three months now. One analysis making the rounds is that we are much less oil-dependent than in the past, so there is little to worry about. The case for not worrying is straightforward.

First, high oil prices are a concern mainly because they act like a tax, pulling money out of the economy and leaving less for other spending. But the amount of oil consumed per dollar of GDP in the U.S. and Canada has fallen by around 40% since 1980, with over one-third of that adjustment occurring since the Gulf War. Canada still uses about 20% more oil per dollar of GDP than the U.S. - it's colder here, and our resource sector uses a lot of energy - but this measure clearly suggests a declining vulnerability to oil shocks.

Second, high oil prices also boost inflation, which can mean higher interest rates and make the slowing effect on the economy even greater. However, the key variable in this analysis is inflation expectations. With the world economy already soft, and pricing power so limited, a generalised surge in inflation expectations seems unlikely. This risk appears slightly higher in Canada, given its stronger economy, hence the Bank of Canada's recent decision to begin edging rates higher.

Even so, most analysts believe that oil prices will ease back later this year, assuming the gradual return of Venezuelan oil supply and some sort of resolution of geopolitical tensions. All well and good. But one risk to this analysis that has not received any attention is the growing importance of international trade to world economic growth. Because of the trend toward globalisation of business, it now takes much more international trade to produce one dollar of GDP than it did in 1990.

Higher oil prices increase the transportation costs of trade, cutting into the profit margins of all global companies. Furthermore, increased interdependence means that growth prospects in other parts of the world matter more to us today than they did 10 years ago. And it just so happens that the world's engine of economic growth, developing Asia, is also the most energy-dependent.

Developing Asia constitutes only about 25% of the world economy, but is likely to contribute more than half of all the world's growth this year. Yet such countries as China and India use about twice as much oil per dollar of GDP than the U.S. South Korea and Thailand are only slightly more efficient than this, but they actually use more oil per dollar of GDP today than they did in 1990, unlike most others. Asia is clearly vulnerable to oil shocks. About 20% of U.S. trade and 6% of Canadian trade is with non-Japan Asia.

Higher oil prices could dent Asian purchasing power much more than in North America, weakening our exports to the region. At the same time, Asian exports to North America will become more costly, and many of those exports are key inputs for North American global companies - another hit to profits.

The bottom line? North America may appear to be less vulnerable to oil shocks than in the past. But North America is becoming increasingly dependent on Asian economic growth, and Asian growth is highly oil-dependent. In short, our vulnerability is probably higher than it seems.

Stephen S. Poloz
Vice-President and Chief Economist
Export Development
Canadaspoloz@edc.ca

 

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