Sterling structurally no longer petro-currency

Although oil prices have risen considerably less in sterling terms than dollars since 2002, the level is still around 80% higher. Half of that adjustment has occurred during the past eight months.

Our economists estimate that a significant portion of the recent rise in oil prices - around $10-$15 - probably reflected speculative forces or a growing fear that future supply could be disrupted.

However, they also argued that the majority of the move over the past year could be attributed to more fundamental factors, namely the failure of supply to match growing world demand.

That suggests that a world of permanently higher oil prices is here to stay. What impact will that have on the UK?

The UK has mirrored the latest trends on oil, particularly that there have been significant reductions in the:

∑ energy intensity of production;

∑ share of oil in total energy consumption

∑ and in the share of oil prices in the retail price of petrol.

In the UK the share of oil as a percentage of total energy consumption has fallen from 45% to around 35% since 1970; the ratio of energy consumption to GDP has fallen by around 50% since 1970 and the share of taxes and excise duties in final petrol prices has risen to around 85%.

Most academic studies tend to conclude that the UK is broadly unaffected by an oil price shock.

Work by the IMF suggests that a 50% rise in the level of oil prices that is sustained could reduce the level of UK GDP by just 0.1%, while temporarily increasing inflation by 0.4%. That is a quarter of the GDP and half the inflation impact envisaged for the US or Eurozone from a similar shock.

The fact that the simulated effects are larger in the US than the UK in part reflects the smaller role crude oil prices have in headline UK CPI and, hence, reducing the likelihood that inflation expectations and wages react to a temporary hit to headline inflation.

The smaller impact also reflects the fact that since the late 1970s, the period in which most forecast models are constructed, the UK was a net exporter of oil.

As petrol prices have a weight of 3.6% in the UK retail price index, the impact of higher oil prices on the CPI is immediate.

However, the fact that around 85% of that weight reflects tax or excise duties means that the impact of crude oil on the CPI is typically very modest. At present the petrol component of the RPI is contributing just 0.3% points to annual inflation, even though sterling crude oil prices have risen by over 30% across that period.

The indirect impact is potentially more significant as higher oil prices gradually feed through the supply chain from manufacturers' input costs to their output prices to retailers eventually. On our estimates a 10% rise in oil prices typically raises input prices by 1.3%, output prices by 0.3% and the CPI by just 0.15%.

While the US and Eurozone economies are operating below capacity and so retailers will find it difficult to pass on their higher costs, in contrast, the UK economic cycle is mature.

According to the Bank of England there is little available spare capacity in the UK and almost full employment, so the possible inflationary consequences may actually be larger in the UK than elsewhere. In that world the response of retailers over the next few months will be critical and closely monitored by the Bank of England.

The evidence of the second round effects in the UK is currently encouraging. Higher oil prices may have caused input price inflation to rise to its highest rate since 2001 and manufacturers' output prices are rising at their fastest pace since 1996, but UK CPI inflation remains incredibly subdued.

At a time of record sales on the high street, retailers appear to be absorbing cost increases through a squeeze on margins rather than higher prices. The question is whether this reflects intense competition among retailers, a huge degree of credibility in the UK inflation-targeting framework or whether it simply reflects the lag within the system?

Despite the upside risk to short-term inflation, an oil price shock will ultimately be interpreted by the Bank of England as having negative demand implications rather than a positive inflation shock, especially if inflation expectations remain stable. Higher oil prices reduce company profitability and/or squeezes consumers' disposable income and, hence, the economy tends to slow.

One key offset to this negative shock is that the UK, unlike the Eurozone or US, has been a net exporter of oil. That has meant an oil price shock has tended to reflect a transfer from consumers to oil companies and the UK government.

The history of the UK and oil goes back to the early 1970s. Following a number of major discoveries in the North Sea, the UK and Norway became significant producers of oil during the late 1970s and through to the mid-1980s. At its peak in 1985 the UK produced 4.5% of the world's total production of oil.

These discoveries had a major impact on the UK economic landscape. The announcement caused a sharp real appreciation of sterling in the late 1970s. This hastened the demise of manufacturing but it also meant that when oil prices rose, wealth was created in other parts of the economy while the trade deficit and government finances received a substantial boost.

Those years, however, are almost gone. Since 1979, there have been only two years in which the oil industry has discovered more oil than it has produced. The large discoveries were during the late 1970s but since then the discoveries have become progressively smaller and have only marginally contributed to the UK's total oil reserves.

A limited supply of oil is a global phenomenon, one that the world will need to come to terms with. However, the pace of decline has been far more rapid in the UK than elsewhere. The UK has gone from averaging 2.7 million barrels a day in 1999 to 1.9 million currently, a drop of 30%.

Geological studies have concluded that there are no more large oilfields to be discovered in the North Sea. At the current size of production, the UK's oil reserves could disappear by 2010-2015.

The question in the UK is not whether production will rise or fall but rather the pace of the decline. The decline has occurred at a time when record oil prices should provide a massive incentive to produce.

If high oil prices persist, oil production may increase but this will bring forward the time when the reserves disappear. As in other countries, in the future higher oil prices will represent a transfer away from consumers towards oil-exporting countries, creating a more negative impact to UK GDP growth. Structurally, sterling is no longer a petro-currency.

This report has been compiled by HSBC Bank Malta pls on the basis of economic research carried out by HSBC International Bank's team of economists and financial experts.