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KWAK Soo-Jong

Getting Prepared for a New Oil Shock

KWAK Soo-Jong

Nov. 2, 2005

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The world is becoming inured to oil price shocks. A quarter of a century after the last price spirals, consumers are once again up in arms over the surging fuel cost. The price hit new highs this year, prompting warnings that it could shoot through the roof of US$160 per barrel in the foreseeable future. A worrisome question raised around the world is: are we hurtling towards the first firestorm of this century's first oil shock?

That may well be the case. The global market is flagging yet another shock in the making. Compare the current market situation in the US with the situation that prevailed after oil shocks in the past, and you will see a familiar sign.

The price of Dubai crude and import prices of the United States as of October 5 were higher than prices of the first oil shock period, but even so, they were $30-40 lower than the prices registered during the period of the second oil shock.

As of October 5, the US retail price of gasoline was 36% higher than the level of the first oil shock, and similar to the level of second oil shock in the 1979-1980 period. As such, the increased amount this time can bring a huge burden to on the US economy and households. That could cause negative ripples around the world.

Korea's economy won't escape from this impact. Its oil import in 2005 is forecast to be around 771 million barrels, up 2.2% from 754 million in 2004. When we forecast economic growth for 2005 early this year, the oil price was estimated at around US$35 per barrel. In October, however, the price had shot up to US$48, bringing an extra burden of US$13 per barrel to our economy. A price increase of that magnitude can cut Korea's GDP by 1.2%. Assuming our original growth forecast was 5% for this year, the oil price increase would have lowered the actual growth rate to 3.8%. If oil price had gone up to US$50 by the end of this year, it would have cut GDP growth to 3.6%.

By the same token, if the price of Dubai crude surged to US$100 per barrel, it would have pushed down our GDP growth to 2.1%, while pushing up our consumer prices to 4.3%. That would in turn have prompted the private sector consumption to slow to a 1-2% level, while facility investment would have dipped into the negative area. All this would have condemned our economy to a protracted period of low growth afflicted with high inflation. The following table shows how oil prices will impact on our macroeconomic indicators.

What impact will all this bring to the corporate sector? Higher oil prices will go on raising production costs of energy-dependent industries, as the recent US airline crisis demonstrates. Some of the l ong-established airline companies in the United States have suffered from steep falls in revenues, creating snowballing debts, as oil prices continue. Corporate profitability is dramatically worsening, dampening new investments, leading to more restructuring and rationalization, and creating more job losses. This is what you mean by a vicious cycle.

It's true that Korea's economy has developed a better resilience to oil price shocks through constant restructuring of its energy-dependent industrial structure. But the government's policy choices or measures for supporting the small- and medium-sized enterprises are too inadequate to protect them from sharp acceleration in energy prices.

Korea's economy is an oil guzzler. To survive the coming challenges of further price increases, the country should be thoroughly prepared against a variety of shock-related scenarios by closely following the market trends. Our economy should be restructured to cushion shocks from price spirals. Without properly assessing the impact of oil price shocks before they arrive, it's impossible to formulate policy response that guarantees a sustained growth of 4.8% in 2006.

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