Three Rules By Which To Avoid An Oil-Price-Caused Recession

With “green shoots” of economic recovery more numerous by the day, dark warnings of a new spike in oil prices are also multiplying. Saudi oil minister Ali Al-Naimi has warned that under-investment in drilling during this recession may lead to a return to $150 oil “or even worse.”

The Paris-based International Energy Agency has also warned of possible price shocks to come—if not this year, then in the future--due to resurgent world demand coupled with restricted investment.

At this writing, oil stands at about $70 per barrel, and by the history books, recession occurs when it reaches $80 per barrel. Oil prices do not have to rally very much to reach unsustainable levels for the U.S. economy.

In the past 37 years, the U.S. has suffered six recessions. From the beginning, rising oil prices have played a central role. But, are oil-price levels the critical factor, or do rapid price increases (price volatility) also matter? We find that recessions correlate well with sustained price increases. The historical record shows that whenever oil prices have increased more than 50% year-on-year (the trailing-12-month average divided by the previous 12-month average), a recession has followed shortly thereafter.

While the case for price volatility remains somewhat circumstantial, in general, a sustained rise in the price of oil of 50% or more has always been followed by a recession.

Oil consumption also plays a role. In every case, when U.S. oil consumption breeched 4% of GDP, the U.S. suffered a recession and, indeed, the current recession began within two months of oil hitting the 4% threshold—that is, when oil reached $80 per barrel.

History then provides us three rules by which to avoid recession caused by oil prices.

-- First, crude oil expenditures should not exceed 4% of GDP.

-- Second, oil prices should not increase by more than 50% year-on-year.

-- Third, oil-price increases should not be so great that a potential demand adjustment should have to reach 0.8% of GDP annually, as shedding demand at this rate always has been associated with a recession.

For safety’s sake, one might wish to target something lower than the maximum “shed” rate, say 0.4% of GDP per year, which equals a price increase of about $8 per barrel per year at current prices. This would be less than a 50% price increase and therefore, reduce consumption without creating a downturn or recession.

The economy cannot shed oil consumption instantaneously: society needs time to adjust. When the economy is adjusting at full speed, it will tend to struggle. Adjustment will be characterized by recession, inflation or low GDP growth.

--Steven R. Kopits

About the author: Steven R. Kopits is a managing director for U.K.-based energy-consulting and -research firm Douglas-Westwood LLC, and is based in New York. He can be reached at steven.kopits@dw-1.com. Click for his full report: Oil--What Price Can America Afford? (whatoilpricecanamericaafford61509).

Nominal And Inflation-Adjusted Oil Prices, 1970-2009

U.S. Oil Consumption As A Percent Of GDP, 1970-2009