Kenneth D. Gartrell

By: Kenneth D. Gartrell

China and India have been blamed by many politicians and pundits for the recent rises in oil prices. Simple economic analysis makes it clear that there cannot be such an impact. It is vitally important to a correct economic analysis that the analyst adopt an “ex ante” perspective. “Ex Post” reasoning is one of the greatest and most common errors in economic reasoning.

I recently investigated the claim that it is the economic growth in China and India that is driving up the price of oil from $60 bbl in 2007 to $140 bbl today. Once we place ourselves in a position to look forward from the date when the prices were paid, we can say without doubt that the recent rise in oil prices is unassociated with growth in China and India.

Here are the basic facts:
First, the price of oil changes only when the market is surprised. Expected long-term growth in China and India on any given day is fully factored into the price. Only unexpected changes in the projected rate of long-term growth of China and India can explain changes in the price of oil.

Second, the regional growth rates in Asia (including China and India) have been as follows: 2004, 6.8%, 2007, 5.8% and 2008 to date 5%.

In an efficient market (of which there is no question about the world oil market) the best unbiased estimate of tomorrow’s price is today’s price. Hence, the price of oil in 2004 would have included an expectation of regional growth in perpetuity of 6.8% for the Asia region. In 2007 that expectation would have fallen to 5.8%. As of today the growth expectation has fallen further to 5%.

Analysis based on the facts clearly reveals that between 2007 and 2008 the impact of expectations for the growth in China and India are entirely inconsistent with increases in the price of oil. When oil has risen almost 200% from $60 bbl to $140 bbl, the expectation of growth in the Asia region has fallen from 5.8% to 5.0% or by 14%.

All other things constant, the rise in oil prices since 2004 cannot be explained in terms of the growth of India and China. The actual underlying effect is a reduction in prices.

QED