Gasoline

Oil Price Shocks and the Recession of 2011?

Ten of the last 11 recessions were preceded by oil price hikes.

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Oil prices surged to near $107 per barrel yesterday and regular gasoline is going for $3.51 per gallon. Last March oil sold for around $80 per barrel and gas cost about $2.79 per gallon. The uprisings throughout the Middle East are in part responsible for the recent uptick in prices. For example, the fighting in Libya has reduced global oil production by about one million barrels per day. On the other hand, members of the Organization of Petroleum Exporting Countries (OPEC) are boosting their output by a similar amount to make up for the shortfall. Democrats in Congress are calling upon President Barack Obama to damp down prices by selling off oil from the Strategic Petroleum Reserve.

Of course, the global oil market is pricing in worries that production could be disrupted if protesters in other major OPEC producers such as Saudi Arabia, Kuwait, and Iran began to demand greater freedom. What would happen to the U.S. economy if petroleum prices continue their rapid rise? University of California, San Diego, economist James Hamilton noted in a recent study that 10 out of 11 post-World War II recessions [PDF] in the United States were preceded by a sharp increase in the price of crude petroleum. The only exception was the mild recession of 1960-61 for which there was no preceding rise in oil prices.

Hamilton has also written a fascinating short history [PDF] of U.S. and global oil price shocks. Until 1974 the United States was both the world's biggest consumer and producer of crude oil. Although domestic oil production has recently upticked, the U.S. today produces about half the oil it did in 1971. It still is the biggest consumer.

It turns out that boom/bust price shocks have been a feature of oil production ever since Edwin Drake drilled his first well in Pennsylvania in 1859. Before Drake's well crude oil was being sold for the equivalent of $2,000 per barrel (2009 dollars). After Drake's discovery, the price of oil collapsed by 1861 to about $2.50 per barrel. In those days, the products of crude oil chiefly competed against ethanol as illuminants. Oil became increasingly important to the U.S. economy as it took over as the chief transport fuel. In 1900, there were 0.1 internal combustion-engine vehicles per 1,000 residents, rising to 87 by 1920, and reaching 816 in 2008.

Between 1915 and 1920 oil consumption in the U.S. nearly doubled. A gasoline "famine" broke out in 1920 on the West Coast, provoking state governments to issue ration cards and prosecute "joyriders." The famine preceded the recession that began in January 1920. The giant oil fields in Texas, California, and Oklahoma came online and oil prices fell 40 percent between 1920 and 1926. By 1931, oil prices had fallen an additional 66 percent. To prevent overproduction, states began to set pumping quotas and Depression-era federal legislation prohibited interstate shipments of oil produced in violation of state regulatory limits. These restrictions did prevent waste, but also boosted prices for producers.

The price shocks after the World War II were generally associated with geopolitical events that significantly disrupted global production. For example, Iran nationalized oil production in 1951 and during the Korean War the U.S. Office of Price Stabilization froze oil prices. In 1956 war broke out when Egypt nationalized the Suez Canal, disrupting oil imports. The biggest geopolitical event for oil prices was the 1973 OPEC oil embargo, which was imposed to punish countries that had supported Israel after it had been attacked by Egypt and Syria. The price of oil doubled. In 1979, the Iranian Revolution resulted in supply disruptions that were then made even worse by the outbreak of the Iran/Iraq War in 1980. Still, in the 1980s, global oil prices collapsed to $12 per barrel.

The next run up in price was associated with Iraq's invasion of Kuwait and the First Persian Gulf War in 1990. While oil prices slowly rose through most of the 1990s, the U.S. and global economy both continued to expand. The 1997 East Asian Financial Crisis led to another collapse during which oil prices once again fell to $12 per barrel by the end of 1998. "A price that perhaps never will be seen again," writes Hamilton. After 2001, Hamilton argues that oil production did not keep up with global economic growth. The result was that the price of oil eventually reached its highest level in modern history, about $142 per barrel in the summer of 2008. Interestingly, the U.S. economy entered what would become the Great Recession in December 2007. By December 2008, the price of oil had dropped to just over $30 per barrel.

Hamilton is not arguing that oil price shocks are the sole cause of recessions, but that they tip an already vulnerable economy into contraction. A 2010 study by economists at the St. Louis Federal Reserve Bank agrees: "For most countries, oil shocks do affect the likelihood of entering a recession. In particular, an average-sized shock to WTI [West Texas Intermediate crude] oil prices increases the probability of recession in the U.S. by nearly 50 percentage points after one year and nearly 90 percentage points after two years." On the other hand, a 2005 study by the Stanford Energy Modeling Forum found that "when oil prices move gradually higher (perhaps somewhat erratically), as they have done over the last several years, they do not directly result in economic recessions, even though the economy may grow modestly slower."  Gradual price increases do not derail economic growth because consumers and entrepreneurs are able to adjust smoothly to them.

So how do oil shocks cause recessions? Hamilton and many other analysts note that the actual amount spent on oil relative to the overall size of the economy initially suggests that the effect of a price increase should be relatively small. For example, as a result of the 1973 oil embargo, the world spent an extra $5.1 billion ($23 billion in 2009 dollars) on oil. Yet, U.S. real GDP declined by 2.5 percent, which is about $38 billion ($164 billion).

One of the key ways oil price hikes negatively affect the U.S. economy is by provoking a decline in demand for new automobiles. Unemployed autoworkers and idled factories can't be rapidly deployed to other sectors. In addition, uncertainty over oil prices also leads people and firms to postpone purchases of capital and durable goods. While higher oil prices contribute to recessions, lower oil prices do not appear to have much effect on economic expansions. People may postpone buying a new car when gas prices are high, but they don't rush out to buy one just because pump prices are low. 

So will the recent run up in the price of crude push the U.S. economy back into recession? The good news is that the U.S. economy grew at a rate of 3.2 percent in the most recent quarter, and gross domestic product has returned to the level it reached in 2007. On March 1, Federal Reserve Chairman Ben Bernanke testified before the Senate's Committee on Banking, Housing, and Urban Affairs that "sustained rises in the prices of oil or other commodities would represent a threat both to economic growth and to overall price stability, particularly if they were to cause inflation expectations to become less well anchored."

The price of oil spiked briefly in 2003 as the result of a strike in Venezuela and the launching of the Second Persian Gulf War. Hamilton points out that actual oil production didn't decline that much and he believes that strong economic growth rode out that short-term price increase. More worryingly, back in 1973 commodity prices also surged dramatically, which coupled with a doubling in the price of oil, resulted in a deep recession. So, is this 1973 or 2003?

Reason's Science Correspondent Ronald Bailey is author of Liberation Biology: The Scientific and Moral Case for the Biotech Revolution (Prometheus Books).

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  1. That’s why we need alternate energy….right Ron?
    And it will stop AGW….right Ron?

    1. as much as it pains me as a libertarian to say this, I am working on an alternative energy project for the DOE and I think I’m going to finish their 2019 milestone this summer. Of course, it’s not really going to solve anyone’s energy problem.

  2. Democrats in Congress are calling upon President Barack Obama to damp down prices by selling off oil from the Strategic Petroleum Reserve.

    1. That is not what the Strategic Petroleum Reserve was created for.
    2. I thought the Dems wanted to raise the price of fossil fuels to combat AGW.

    But if you don’t vote for one of the major parties you’re not a serious person.

    1. Not quite.

      The Congresscritters do not want private corporations to benefit from the rising value of their inventories.

      The Congresscritters are perfectly willing to TAX, however. That is not a “price increase” in their minds.

  3. “the U.S. today produces about half the oil it did in 1971”

    Because of political reasons. Mainly, the federal government claiming to “own” land and offshore water, and determining who is allowed to obtain the resources from it.

    1. America reached peak production and declined, just like dozens of other countries. Most of America’s remaining oil is locked in shale or buried deep underwater. Throw open the gates to drilling, and we’re still not likely to get near 1970s production levels.

      1. so drilling is actually not allowed right now eh?

        1. Throw open the gates to drilling, and we’re still not likely to get near 1970s production levels.

      2. Actually, shale fracking is growing exponentially, with more horizontal well segments and increasing use of fracking for oil as well as natural gas. The Bakken Shale alone may hold as much carbon energy as Saudi Arabia. I don’t know what will happen, but an increase well beyond the 1970s level is entirely feasible.

        1. My customers who sell frac tanks can’t build them fast enough to fill their orders. And old ones are renting for 3 times the rate from a couple of years ago.

  4. @Colonel_Angus

    The U.S. produces about half the oil it did in the 70’s because we have sucked the wells dry, and while active rigs have actually gone up, yes up in the past couple years, no new domestic discoveries are on the scale of the super fields of years past that are now mostly depleted.

    America could squeeze some more out of our soil and oceans, but not indefinitely, and not enough to meet our demand at the voracious rate we burn through the stuff.

    1. There is still an assload of easily accessible oil fields that aren’t being mined because of environmental and aesthetic shit.

      1. Well we could drill at ANWR but for our respect for the sex lives of wild animals.

        1. Not that there’s anything wrong with that

        2. Please, think of the moose and mosquitos!

    2. When I shut down those rigs, I was under orders to do so, and you can bet your ass the political influence of Saudis was behind it. It had absolutely nothing to do with dwindling supply.

    3. Just to show you how wrong you are, before the Saudi backed Greens managed to gut our crude oil industry through political means, we had a more extensive infrastructure of production than Mexico. We killed off our rigs, and Mexico has managed to produce at a high volume ever since then, taking up our slack in many of the very same fields you claim to have been rendered useless back in the 70’s! Whereas our industry dwindled from being a major player to a net importer. Politics killed the industry.

      1. I take some solace in knowing that, so long as we don’t extract it, it pretty much sits there until we decide to. On the fairly reasonable assumption that oil and gas 100 years from now will be worth more than it is now, even a time-value analysis suggests it’s not terribly harmful to postpone extraction.

        As I said, SOME solace.

        1. Maybe, but then there’s the cost of having aircraft carriers and divisions of soldiers to protect the foreign supply.

  5. How many office workers sitting in traffic in the morning and at night could be taken off the roads if only greater freedom would be given to those who want to telecommute — and telecommuting forced upon those technophobic Baby Boomers still in the workplace?

    Obviously, not everyone can telecommute. But surely the population that can is greater than the 10 percent that currently does.

    Telecommuting got me through the 2008 run up in gas prices. It was nice to fill up once every couple of months or so.

    There’s a salutary benefit to telecommuting — no more annoying personal habits of co-workers disrupting my day.

    1. I hear you on the technophobic Baby Boomers. My boss is one such person. She keeps trying to keep us from emailing our reports and instead wants us to DRIVE them to their recipients.

      She’s afraid someone will hack our email somehow or something equally ridiculous. We password protect them anyway, but I don’t think she understands the concept.

      Also, I work for the state government so that probably explains why someone the promotes that level of inefficiency still has a job.

      1. Man, do i hear ya. We had a luddite project manager about 17 years ago who thought we should either a) hand-write our reports, or b) (dear lord) DICTATE them to little audiotapes, and then have a word-processor type them. I think he was screwing the girls in the typing pool, and wanted to make sure his candy store didn’t get laid off (pun intended)…

    2. I telecommute as well. You save so much money and time it’s crazy. In 3 mos time I’ll barely put 1000 miles on my car.

  6. Thorium Reactors. Energy problem solved.

  7. Bender: So we’re boned?

    Leela: Yeah, we’re boned.

    … Hobbit

  8. More worryingly, back in 1973 commodity prices also surged dramatically, which coupled with a doubling in the price of oil, resulted in a deep recession. So, is this 1973 or 2003?

    Considering that Bernanke’s QE has resulted in commodity prices going through the roof, I’d say the answer is pretty obvious.

    1. There’s still time to impose price and wage freezes! All is not lost! WTF!

      1. Nixon’s the One!!!

        The One is Nixon!!!

  9. The good news is that the U.S. economy grew at a rate of 3.2 percent in the most recent quarter, and gross domestic product has returned to the level it reached in 2007.

    The bad news is that many, many millions of people are unemployed in 2011 who were not unemployed in 2007. And many, many millions more have lost their homes or are currently in foreclosure who were not in those circumstances in 2007.

    While inflating the money supply and giving banks “free money” to use in the stock market may have artificially pushed our nation’s economic indicators back into the green, we are far, far from out of the woods on the last recession. If we have another recession, the effects will be greatly magnified over what similar conditions would have caused in 2007.

  10. the tens of thousands of people who come there every year would not exist.

    That’s right, without all that cowboy poetry those people simply would not exist. Gone, poof, back to the ether.

    1. Ooops, wrong post

  11. The good news is that the U.S. economy grew at a rate of 3.2 percent in the most recent quarter, and gross domestic product has returned to the level it reached in 2007

    Assuming, of course, that the GDP numbers (which include government spending) are meaningful. And further assuming that they aren’t cooked.

  12. Ronald Bailey needs acquaint himself with “Gov Shadow Stats” and “Crash Course”. The material underestimating of inflation and boosting of GDP for HEDONICS give an artificial boost to the GDP number (real GDP is adjusted for inflation via the ‘GDP Deflator’). If the GDP is so good, why are not state tax revenues improving?

  13. I enjoy the juxtaposition of these two sentences:
    “the global oil market is pricing in worries that production could be disrupted if protesters in other major OPEC producers such as Saudi Arabia, Kuwait, and Iran began to demand greater freedom. What would happen to the U.S. economy if petroleum prices continue their rapid rise?”

    Worded otherwise, “what would happen to the US economy if citizens of other major OPEC producers attempted to be free?”

  14. the tens of thousands of people who come there every year would not exist.

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  19. Throw open the gates to drilling, and we’re still not likely to get near 1970s production levels.

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