Rising prices oil wheels of Scotland's offshore industry; Next year

OIL price hikes keep company with miners' strikes and hurried visits to the International Monetary Fund (IMF) in our economic folk memory. Until recently, the price of oil had been a matter of little economic or political consequence for almost a decade. However, from a 50-year low in real terms of less than $10 (#6.90) per barrel in December 1998, the price more than trebled to around $35 in September. Will this have effects on the wider economy and what could it mean for the oil industry in Scotland?

In principle, there could be two macro-economic impacts. First, economic growth could slow and some people argue there might be a recession. Higher prices are like a rise in taxes for oil-consuming countries. They reduce the income available for other activities. For oil producers, higher oil prices are a windfall gain. Thus, the rise in the oil price redistributes income from consumers to producers.

In itself, that need not affect growth. One reason why previous oil price hikes have contributed to recessions is oil consumers have cut spending faster than producers have spent their gains. That means the responses of the winners and losers are a crucial determinant of the likelihood and the scale of any fall in growth. However, it is very difficult to anticipate precisely what those responses will be.

It is likely that world growth will fall, but forecasts of recession are premature at best. The IMF estimates that if the increase in the oil price since the middle of the year were sustained, growth in the major industrialised countries would fall by 0.2%. To put that in context, growth this year is likely to be around 4.2%, up from 3.2% in 1999. So, while higher oil prices could damage growth further and could even cause a recession, the most likely outcome is slower, but healthy growth.

Since the UK is an oil producer, growth here will benefit from higher prices, mainly through increased returns for oil companies. The profits of UK Continental Shelf producers rose sharply in the second quarter of this year. Net returns rose by more than 6% to 33.1% in the second quarter. That compares with the average rate of return for non-oil companies of 11.7%.

THE second main macro-economic effect is on inflation. That is already evident in the UK. Producers' input prices rose by 14.5% in the year to September and higher oil prices were the principal cause.

However, the inflationary backdrop and monetary policy are very different from the times of previous oil price rises. Underlying inflation has been below the target of 2.5% for 18 months. While the Monetary Policy Committee has to set interest rates to hit the target, it believes rates will have to rise only if oil prices rise further or the recent oil price increase feeds into inflation expectations. Thus, the well-publicised rises in petrol prices have little affected the long-term inflation outlook.

Beyond these direct effects, there remains the risk that equity prices fall if the markets take fright at the prospect, or reality of conflict in the Middle East.

The fall in the oil price in 1998 had damaged oil companies' cashflows and profits. They responded by reducing investment spending and seeking a range of cost reductions. One effect was a marked decline in offshore activity in the UK.

The good news from the last two difficult years for the oil industry in Scotland is that is has become increasingly efficient. Costs have been reduced and continue to fall. That, more than $30- $35 oil, is why 2001 will be the best year for the offshore industry in Scotland since 1998.

Stephen Boyle is head of business economics at Royal Bank of Scotland www.texaco.com www.chevron.com

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