Driven to despair

A HOUSING slump across America; a global credit crisis; crashing banks and tumbling house prices; a food price spike, growing fears of recession, and now, just when you thought the news could not get worse, a new oil price super spike to more than $130 a barrel.

Any one of these developments would threaten a recession. Indeed, America's central bank is already struggling to stave off the worst financial crisis since the Great Depression. But together they put beyond doubt the fact that the world has moved from one era to another, and one altogether less stable and reassuring.

Deepening gloom in housing markets in America and Britain has hit directly at household wealth and the basis of the consumer borrowing and spending surge that has fuelled growth for the past five years. Soaring prices of raw materials and foodstuffs have sparked riots across the world and hit world's poor.

But the skyrocketing price of oil – up 60% this year, double the level of 12 months ago and up 400% on the level in 2001 – has wider and more painful consequences than a housing slump or dearer food. It risks making recession a fact across many parts of the world. It will force households into even further cutbacks, drive companies into retrenchment and put governments under intense and often destabilising pressure.

Across the economies of Southeast Asia, costly and elaborate government oil and food subsidies have protected millions from the worst of the price spiral. These subsidies are now likely to be drastically modified or swept away altogether, compounding the problems of poorer households.

The run in oil has pushed fuel bills to the point at which British drivers this Bank Holiday weekend could pay up to £110m more for petrol than they did a year ago. The average price of diesel has shot up by 6.76p per litre during the past month to 124.17p, while the average price of petrol has risen from 108.06p to 112.55p per litre – or £5.06 a gallon. Little wonder the British Chambers of Commerce has called on the Government to abandon plans to increase petrol duty by 2p per litre in October.

The oil surge is already having wider and more severe effects. Last week American Airlines said it was mothballing 75 planes and introducing a minimum baggage charge of $15 an item. Smaller airlines, such as business class airline Silverjet, will struggle to raise cash. Cheap air travel is fast disappearing.

Ford has slashed production of its gas-guzzler cars, while tens of thousands of smaller companies will have to quickly adapt – or go to the wall.

Every manufacturing company is now under the cosh of rising input prices. Indeed, even before the latest upward twist to the oil price, raw material costs for UK companies were racing ahead at an appalling annual rate of 23% – a pace not seen since the stagflation years of the mid-1970s.

Households and businesses hoping for rates to come down to 4% by autumn have now had this prospect removed as a beleaguered Bank of England struggles to hold down inflation. So what has been driving up the price of oil on a daily basis? One big factor has been a surge of speculative activity by market traders and hedge funds that have piled into the futures markets, with the result that the future price of oil is now higher than the spot price today.

Today's oil supplies are not the driver. It is the belief that in the medium term we are facing a permanent oil shortfall. Veteran oil trader T Boone Pickens has predicted that oil could hit $150 a barrel within weeks. Goldman Sachs energy analyst Argun Murti, who correctly predicted that oil would smash through $100 a barrel, predicts the price of oil could now soar to $200 a barrel in as little as six months.

US economy analyst Ed Yardeni says "peak oil' theory, once on the fringe, has gone mainstream in the past few weeks as oil prices have soared to levels that only the peak oil theorists anticipated.

The spot price is being driven up by soaring futures prices even though the spot market is awash with so much oil that Iran has stored 10 to 12 offshore oil vessels in the Persian Gulf for lack of buyers.

The International Energy Agency, the world's leading energy monitor, is said to be preparing a sharp downward revision of its oil-supply forecast, a shift that reflects deepening pessimism over whether oil companies can keep abreast of booming demand. The Paris-based IEA is in the middle of its first attempt to comprehensively assess the condition of the world's top 400 oil fields. Its findings won't be released until November, but the bottom line is already clear: future crude supplies could be far tighter than previously thought.

According to a Reuters survey of 12 analysts, oil production from countries outside Opec is stagnating and forecast to remain below 50 million barrels per day this year, at 49.56 million barrels per day, lower than earlier forecast.

An unexpected fall in Russian oil production was one of the main factors prompting forecasters to revise down their projections of non-Opec supply.

But others dispute these projections, pointing to actual or pledged production increases by Iran, Iraq and several non-Opec producers. They also point out that oil consumers across the world are already responding to the new reality by cutting back on consumption. Oil cannot long continue to rise when demand growth is falling.

Meanwhile, barely a week now passes without further downgrades to economic forecasts. Prospects for the US, which accounts for 24% of world oil usage, continue to be grim, with the Federal Reserve warning of a slowdown that just stops short of mentioning the 'R' word.

News last Friday that the housing market is continuing to struggle confirms that recession in the world's biggest economy is all but official. House sales fell by 1% month-on-month in April, prices are down by 8% on a year ago and house sales are down 17.5%. Across the Euro zone, growth is now slipping after an encouraging start led by Germany, whose export sector has performed well. But purchasing managers' index data released on Friday showed that sentiment in both the Euro zone's manufacturing industry and services sector darkened in May.

The decline in purchasing managers' expectations coincides with increasing pressure on profit margins from the soaring oil price. Moreover, slowing demand reduces the chances that input price increases can be fully passed on to customers and hence increasing the pressure on profit margins.

Some fear that the hawkish European Central Bank will not cut but raise interest rates in the autumn to counter inflation now running at 3.3% – a move that would almost certainly incense French president Nicolas Sarkozy and others.

As for the UK, the Bank of England warned late last week that the economy is set to slow from a growth rate of 3.3% in 2007 to just 1.5% in 2010 and is likely to grow by no more than 2.4% – below its long term trend rate – in 2010.

Monetary policy is now caught in a deadly vice – between pressure to lower interest rates to help relieve a disastrous plunge in housing activity and in particular new house starts, and the threat of inflation rising on the official CPI measure to between 3.7% and 4% later this year. Markets are now discounting a serious likelihood that the MPC will raise rates this year. Such a move would be deadly for millions of households and push an already deeply depressed housing market into a state of crisis. But it is the prospect of a severe slowdown that the Bank is now counting on to bring inflation back down towards its 2% target rate in 2010. Not since the 1970s has the UK faced such a lethal combination of sharply rising inflation and a deep downturn in economic activity. This is not just stagflation, but Stagflation Max. Scotland has so far escaped relatively lightly.

But as soaring oil fuels the inflation fire, we are all going to feel weekly budgets under severe pressure. That squeeze should work to bring down oil prices – possibly quite quickly. But demands on a weakened Government to halt further rises in fuel duty will intensify.

The question in these circumstances is whether Gordon Brown will be able to survive until 2010 or be forced out beforehand. In today's new era, the big beasts of the previous one are unlikely to survive.