Andrew Sentance of the Bank of England has issued a very clear analysis of current oil and commodity price movements. It rejects the view that these have been primarily caused by speculators. Instead, it points to increasing demand, and lack of supply, as the main causes of today's higher prices. The slide above sums up his case, showing recent increases in non-OECD oil demand in light blue, the OECD increase in dark blue, and supply increases in purple.
The diamond shape (◊) shows total demand, which has run well ahead of supply until this year. And today's supply/demand balance, is only due to the demand destruction caused by higher oil prices in OECD countries. Non-OECD demand continues at similar levels to 2005-7, due to subsidies. Sentance analyses the situation as follows:
• Investment in non-OECD countries tends to be in capital goods and new building work, 'which require large amounts of materials and energy'.
• Consumers in non-OECD countries spend more of their income on physical products, whereas OECD consumers purchase more services.
• The fall in energy prices between 1986-2003 discouraged producers from 'investing strongly in new capacity', or in developing alternatives.
Sentance concludes that it is essential to bring inflation back under control. He says central banks must now raise interest rates to 'squeeze spending and incomes', even though this will have adverse 'consequences for economic growth and employment in the short term'. Those preparing 2009 Budgets might want to include this Scenario in their planning.