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2009 June 29 Monday
Oil Price Surges Cause Recessions

Steve Kopits of energy business analysts Douglas-Westwood argues that energy price surges cause many of our economic recessions. Watch out for oil prices that take oil's cost above 4% of GDP. That's around $80 per barrel. Does that mean we are close to a double dip recession?

In the last 37 years, the US has suffered six recessions. From the beginning, oil played a central role. As the period opened in 1972, Saudi Arabia was selling oil for about US$2.50/bbl – or about $13.50 in today’s prices. Oil had seen a decade of unprecedented growth. The US and Western Europe were finishing the process of motorization of their societies, and demand had soared from just over 20 MMbbl/d in 1960, to more than 50 MMbbl/d by 1972. At the same time, US oil production had peaked in 1970 and had begun to decline. The time was ripe for a shift of power to the up-and-coming OPEC producers, and it was not long in coming.

The price level at which oil hits 4% of GDP depends on how big is the GDP, how much oil we are using, and the price of oil. Our oil demand peaked in 2007. We are a few million barrels a day below that peak now. On the other hand, our economy is smaller too. When oil production starts shrinking after world oil production peaks will the economy contract as fast as oil production declines? Probably not. But it is not clear to me what percentage of the GDP we'll use per 1% of oil lost to declining production.

The US economy has tended to grow well when oil consumption expenditures were less than 2% of GDP. In the early 1970s, for example, oil ranged from 1% to 2% of GDP. By contrast, from 1973 through 1978, oil consumption’s share of the economy peaked as high as 6.3%, never fell below 4%, and averaged 5.3% of GDP. In other words, oil expenditures represented a drag of about 3% of the economy throughout the period.

He say once the economy goes above 4% of GDP going to energy it will go into a recession. Then it can't readjust oil consumption downward by an amount equal to more than 0.8% of GDP per year. I'm unclear on what he means by this point. So if the economy is spending 6% on GDP and prices stay even the economy can cut consumption down far enough to lower oil consumption costs to 5.2% of GDP? It is not clear.

He says the US economy needs to avoid 3 conditions in order to avoid an oil-caused recession.

1. Crude oil expenditures should not exceed 4% of GDP.
2. Oil prices should not increase by more than 50% year-on-year.
3. Oil price increases should not be so great that a potential demand adjustment should have to reach 0.8% of GDP on an annual basis, as shedding demand at this rate has generally been associated with recession.

This report reinforces my belief that we can't avoid an extended and deep economic downturn more akin to a Depression. Once Peak Oil hits and world production starts declining by 3-4-5% per year I see no way to avoid a continual oil shock with sustained prices larger than these numbers. Our decline in consumption over the last 2 years is nothing compared to what's coming. The US economy and that of most other nations will enter into an economic contraction that will continue for years.

You can also read the report as a PDF.

Update: What I worry about: eventual collapse. Parasitism keeps building up. The system can't get enough resources to feed all the burdens placed on it.

Share |      By Randall Parker at 2009 June 29 08:31 PM  Economics Energy


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Comments
miles said at June 30, 2009 1:47 AM:

Randall,


I know this will seem naive, but Ive thought (for years!) that eventually we'd have battery-powered cars and lots of nuclear plants to make electricity for them for the most part, and what precious oil reserves we have would be used only by planes and the military for the most part. I thought the cars would be "refueled" at charging stations right where the current gas stations are for long trips, and right in our garages overnight.

I also thought these "future" cars would look a bit different than the cars we have now in that they'd have a large area (think hatchback) for a large battery that could really store some juice in it (at least 100 miles per charge........and probably more like 300 miles per charge). Nuclear is the way to go in my opinion for the most part, and if any of that pollyanna stuff about helium 3 on the moon really works, then why not.

The only way peak oil will devastate our economy is if our leaders sit on their collective butts and dont do something about it while we still have time to do so, but they are so spineless that they may indeed wait until oil production starts falling before noticing that despite generous campaign donations, we might ought want to get on the ball and head this thing off.


Ive optomistically thought for years that there was probably more oil yet to be discovered in the earth, but even if there is twice as much as we thought, it would still eventually run out....................while we have enough uranium and plutonium to give us juice for a long, long time. Its amazing some hippies protesting has impeded progress this long. Perhaps our electric companies will have more luck building plants in Mexico and Canada to ship big E on the lines to us here. Weve simply have GOT to have personal transportation.

A.Prole said at June 30, 2009 3:21 AM:

According to classical economics (and to plain common sense), an 'oil price surge' (just like any other commodity price surge), should have zero effect on economic growth.
Why? - because money has only shifted out of one set of hands to another, and the reciving pair of hands will use that cash to buy cheap goods from the donor nations.The only effect should be a net transfer of wealth and production (ie a drop in living standards, but NOT a recession), in the donor nations.The effect on employment should be neutral.
But in our fucked-up world, this never happens, all we seem to get economic armageddon.
Why?

Randall Parker said at June 30, 2009 7:59 AM:

miles,

Nuclear power costs less than solar and wind and even less than some other electric power sources. So it makes a lot of sense.

Our problem with the scheme you envision is that it takes time and money to implement. People aren't going to sign up for this migration until they discover it is necessary. Now, I know it is necessary because I read a lot about fossil fuels resource depletion. But I'm not exactly mainstream in my thinking. I can point you at a lot of people who share similar views. But they are in the distinct minority too.

We can develop substitutes, migrate to substitutes, and maintain an industrial economy. But we are going to delay the migration until it is extremely obvious that it is necessary. At that point oil production will be dropping way faster than substitutes can be developed. It takes time to turn over the car fleet. It takes time to build nukes. It takes time to build battery factories.

The transition will be painful because our existing capital infrastructure will become less usable every day and it will produce less every day. At the same time we will need to further reduce consumption in order to divert more output to capital investment. So living standards will drop. Unemployment will go way up.

bbartlog said at June 30, 2009 8:12 AM:

According to classical economics (and to plain common sense), an 'oil price surge' (just like any other commodity price surge), should have zero effect on economic growth.

I don't know what classical economics you are referring to (and as for common sense, I can only say that my sense of things is different). But it seems rather obvious that if there exists some resource that functions as an input to all production, and that resource gradually becomes exhausted, economic growth will decline. Now of course this overstates the role of oil and ignores the existence of substitutes, but my point is that I think you're wrong about what economics (classical or otherwise) says about this situation.

money has only shifted out of one set of hands to another

Yes, if oil were something that we drank like beer, then the situation you outline would apply. But even in the limited case of gasoline consumption, this isn't accurate - the miles we drive are themselves an input to employment and further production.

matlock said at June 30, 2009 9:47 PM:

I agree with Miles, the disruptive effect of an end of cheap energy on society is hard to understate - it effects how and what we can eat, what goods we can produce and consume, where we can live, work and how and if we can get around. It has the potential to crash living standards long before global warming, medicaid and social security problems get their chance (although the potential collapse in the financial system and hyper-inflationary/deflationary depression may give peak oil a run for its money).

To my mind coming up with ways to ensure that the US [and the world] has an ongoing supply cheap energy needs to be almost the number 1 priority for the US Govt. In most instances simply chucking money at a problem does little. I believe that this may be an exception to the rule. The equivalent of a Manhattan Project for energy should be established at dozens of locations bringing the best global minds from military research, academia and industry together. Lots of money for blue sky thinking, lots for incremental improvements to solar, wind generation, batteries etc and lots of money to upscale anything that comes out. Get the Fed to print another $300 billion per year and spend it on this. This needs to start yesterday. No guarantees but if you get the best people and chuck huge amounts of money at the problem you give yourself a fighting chance.

The above is atleast possible. Preserving any sort of standard of living post peak oil will not be.

A.Prole said at July 1, 2009 3:38 AM:

bbartlog,
No, silly-bollocks, that's not what I mean.
The MONEY STOCK (before polliticians started to fuck around with it), is totally unaffected whether the price of oil is $10 a barell or $1000 a barrel.Now, if the Arabs are awash with cash from a $1000 a barrel oil price they will (Gosh can you understand this point?), spend the money on imports from oil buying states.
All that happens is wealth and production is shifted from the buyers to the sellers, comprendre?
If a certain industrial process burns up tons of oil, then all else being equal the Arabs still have the cash to buy up the products of that process (if is indeed essential), and the industry doesn't die.Of course westerners couldn't afford to run cars at that price, but the Arabs still could.

Just why is the free-market so dimly understood?

bbartlog said at July 1, 2009 10:13 AM:

Just why is the free-market so dimly understood?

Given that
A) the empirical evidence for oil price shocks hurting economic growth is strong, and
B) this doesn't seem to be even slightly theoretically controversial for free market economists,

I'd say you should review your underlying assumption that you understand economics and others don't. But, to address just one point of your argument: your point about $100 per dollar oil versus $1000 per dollar oil assumes ignores both the factors and causes that would be required to drive this price change, and also the effects on the ability to buy other production inputs that would result from oil at $1K per barrel.

Let's look at a toy economy. Country A produces oil, O, and consumes goods G. It exports 100 units of O for $100 and imports 100 units of G for $100 . Country B imports oil and both consumes and exports G, but provides labor L. It produces two units of G with inputs one O and one L. It exports 100 units of G for $100 and imports 100 units of O for $100; domestically, 100 units of G are sold for $100 and one hundred units of L bought for $100. Total sales G+O+L = $400.
Now, suppose oil becomes scarcer: Country A can now only produce 90 units, and the price goes up. The new equilibrium will depend on what values we assume for various elasticities of supply and demand, but (assuming no negative slopes for demand or similar weirdness) the specifics don't matter that much. One possible outcome looks like this:
Country A exports 90 units of O for $110, and imports 99 units of G for $110. Country B now produces 180 units of G (using 90 units of L plus the imported O), 81 of which are sold domestically for $90. $90 still buys 90 units of labor. Total sales G+O+L = $400.

'Hah'! You say. 'I was right - no change!'. Not so fast. Economics is not at its foundation concerned with bookkeeping identities, but with production and consumption. Reflecting this, those who calculate GDP and the like make adjustments for inflation. In the second case, the price of oil has risen 10% and the price of goods 11%, while the price of labor has remained unchanged. Depending on how we calculate inflation, our real GDP has fallen by something like 10% in this example. And this is as it should be - ten percent less of everything is being produced.

I think in some sense you are trying to divorce the price number ($1K per barrel) from the real circumstances that would be required to cause such a price, namely, tremendously less oil than we currently are producing. Think of other inputs to our economy: if we had half as much sunshine, would our GDP suffer (prices might go up... but...). If we had half as many people working, would GDP still remain unchanged? You argument frankly makes no sense, and reflects a misguided focus on monetary quantities rather than real input and output.

Randall Parker said at July 1, 2009 3:19 PM:

A.Prole,

A few points:

1) Markets do not readjust instantly. When Americans suddenly can't afford to do activities they previously did they lose their jobs. Businesses close. There are transition costs.

2) The OPEC exporters do not totally win the price increase. The costs of oil extraction are rising. So their costs and the costs of other producers are rising. So they suffer from declining productivity.

3) Some of the exporters have declining production. More will suffer declining production in the next 5 years.

4) Less ability to buy expensive oil means that productivity declines as more capital and labor have to be substituted for the oil.

So it is not just a matter of shifting money around.

A. Prole said at July 2, 2009 3:27 AM:

'The price of labor is unchanged'.
Before polticians statred fucking around with paper money, the only measure of a country's wealth was the tonnage of gold it possesed.
A nation that persistently had a trade deficit drained money - and therefore drained wealth (believe it or not there is a relationship between money stock and wealth).
The drained money stock caused a real deflation in the deficit nation in which ALL prices including that of labor were depressed and suffered a real decline.
This is why nations previous to the 19th century feared trade deficits like they feared Hell and instituted mercantilist policies to prevent them from ever happening.
But the pioneering classical economists such as Adam Smith and David Ricardo theorized that under the conditions of free trade a 'self equilibrium' will emerge under which it would be advantageous for the the surplus nation to buy labor intensive and other goods from the deficit nation, thusly giving them some of 'their gold; back enabling them to use the under utilized resources and labor in a manner that is primarily beneficial to the surplus nation.
- Hence there is no rise in unemployment - only that real wealth and production has shifted to the surplus people.
That was the only point I was trying to make.
Dubai is the physical witness to this phenomenom.
This is really the story of the whole of economics - every time you buy a car from Ford, all that you are really doing is foregoing the benefit of your own cash to be spent on pleasures other than a car, so that eventually the Ford family can live high off the hog with private schools, permanent vacations etc etc.

bbartlog said at July 2, 2009 1:03 PM:

I suppose it's possible you understand economics, but you're terribly bad at expressing your ideas - you've tried to compress about 3 pages of stuff into 3 telegraphic paragraphs. Some places where I can't even see what you're trying to say:

the only measure of a country's wealth was the tonnage of gold it possesed

Are you saying that this was the perception (measure) of the time, or that even in retrospect we should apply this measure? I would apply different measures, and further claim that one reason for the obsession with gold was that it allowed for efficient extraction of rents by the ruling classes.

The drained money stock caused a real deflation in the deficit nation in which ALL prices including that of labor were depressed and suffered a real decline.

Example? Cite? Reasoning? Monetary deflation may or may not cause a decline in real wages. Real wages rose during part of the Great Depression (though this was in part due to gov't policies). Sticky wages may result in wages not declining as fast as overall prices, which results in a similar effect.

But the pioneering classical economists such as Adam Smith and David Ricardo theorized that under the conditions of free trade a 'self equilibrium' will emerge

Smith and Ricardo were engaging in description of what was, not an imagining of what might be. You *seem* to be claiming that mercantilist policies were economically rational, but that thanks to Smith and Ricardo we found a better way. This is not accurate. It is possible that some *other* groundwork made mercantilism obsolete (like the emergence of international banking in the 15th-16th century or so), or that it was never a particularly sound economic policy to begin with, but if so Smith and Ricardo are chroniclers of the event after the fact, not drivers.

giving them some of 'their gold; back enabling them to use the under utilized resources and labor in a manner that is primarily beneficial to the surplus nation.

This is either a complicated way of saying that someone is buying something from someone else, or so mangled that it makes no sense at all.

This is really the story of the whole of economics - every time you buy a car from Ford, all that you are really doing is foregoing the benefit of your own cash

I don't think most people would agree with this characterization. Production inputs and outputs, price as a signaling mechanism, the difficulty of allocating scarce resources... there is a lot of economics that has little to do with money per se. Frankly you sound like someone who has read a few non-mainstream books on monetary theory and now thinks he's got the whole world in his head. But regardless of your actual knowledge or lack thereof you should work on expressing your ideas more clearly...

A.Prole said at July 3, 2009 3:35 AM:

I don't have much time to write these posts, so I rattle them off.
Prior to the British championing of 'free trade' (ideologically driven due to Ricardo's theory), virtually every nation on Earth practised mercantilist policies of some sort - many European nations were literally bankrupted due to exhaustion of their national treasuries, in fact the roman Empire during the reign of Diocletian was bankrupt, he was forced to issue a worthless base metal currency and inflation soared.
The USA, for example, soon after its founding imposed very heavy tarriffs and restrictions on foreign shipping in order to preserve the gold stock.The great inflation that destroyed Weimar Germany was due to its gold stocks being lost to reparations and worthless paper being substituted for real currency.
Like it or not, the depletion of the natiional reasuery ie the gold stock was always but always the bug-bear of most countries of the world.
Nixon, of course, ended gold convertibility in 1971.The issue hasn't gone away - it's new manifestation is the credit crunch.


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