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A Look at the Connection Between Oil Price Shocks and Recessions

I want to bring to the attention of readers a recent paper by James Hamilton, called Historical Oil Shocks (also here as a National Bureau of Economic Research Working Paper). The paper seems to suggest an amazingly close connection between oil price shocks and recession–almost an “if and only if” situation.

Oil Shocks
Table 1. Significant post-World War II recessions and their connection to oil shocks (from Hamilton paper "Historical Oil Shocks")

The paper starts by discussing a long series of oil shocks, and what happened in each case afterword. It concludes with a “Discussion” section. On page 26 in the “Discussion” section it says,

The last column of Table 1 reports the starting date of U.S. recessions as determined by the National Bureau of Economic Research. All but one of the 11 postwar recessions were associated with an increase in the price of oil, the single exception being the recession of 1960. Likewise, all but one of the 12 oil price episodes listed in Table 1 were accompanied by U.S. recessions, the single exception being the 2003 oil price increase associated with the Venezuelan unrest and second Persian Gulf War.

Hamilton can only explain part of this high correlation using neoclassical techniques. But he ends his paper with this statement, indicating that he expects that more of the same is ahead.

In addition to disruptions in supply arising from geopolitical events, another contributing factor for several of the historical episodes is the interaction of growing petroleum demand with production declines from the mature producing fields on which the world had come to depend. In the postwar experience, this appears to be part of the story behind the 1973-1974 and 2007-2008 oil price spikes, and, going back in time, in the 1862-1864 and 1895 price run-ups as well. It is unclear as of this writing where the added global production will come from to replace traditional sources such as the North Sea, Mexico, and Saudi Arabia, if production from the latter has indeed peaked.

But given the record of geopolitical instability in the Middle East, and the projected phenomenal surge in demand from the newly industrialized countries, it seems quite reasonable to expect that within the next decade we will have an additional row of data to add to Table 1 with which to inform our understanding of the economic consequences of oil shocks.

I find the close correlation that Hamilton discovers helpful because it fits in very well with what I would expect when I look at the economy in a non-neoclassical way. Many readers are familiar with the kinds of things I have been saying, some of which have been said by quite a number of biophysical economics writers, and some of which are my own insights. These would include

• The fact that economic growth is correlated with rising oil use;
• The fact that it is much easier to pay back debt with interest in a growing economy than in a flat or declining economy, so declining oil availability is likely to lead to declining credit availability;
• The fact that a decline in credit availability is likely to reduce demand for a wide range of products including new cars and more expensive homes;
• The fact that reduced demand for moving to a more expensive homes is likely to result in a drop in home prices, and increased default rates; and
• The fact that high cost of oil extraction tends to be correlated with low Energy Return on Energy Invested (EROI).

If in fact there is both (1) a close connection oil price shocks and recession, and (2) a reason behind the close connection, then it would make sense for those for whom recession makes a difference–such as insurance companies, banks, stock market investors, and pension plans–to start watching oil prices, and trends in oil availability, in order to forecast future recessions. (In fact, even if there isn’t a good understanding of the underlying reason, it might make sense to use a spike in oil prices as a predictor of recession, since such a high correlation suggests “something” is going on, even if the reasons are not fully understood.)

Could an electricity price spike also cause recession?

I am not convinced there is an “if and only if” relationship between oil and recessions. While a spike in oil prices tends to cause recessions, I am suspicious that a spike in electricity prices would also cause recession, since it is major source of energy supply that also presents a significant cost to consumers (although lacking the “imported” aspect). We haven’t had a significant enough electricity price spike to test this theory. One way such a spike could occur is through a steep rise in natural gas prices; another is through the addition of high-priced renewables. Rembrandt Koppelaar provided the table of electricity costs shown as Table 2, below, in a recent Oil Drum post.

Median and cost ranges for seven different electricity
Table 2. Median and cost ranges for seven different electricity sources at a 5% and 10% interest rate. Amounts exclude charge for cost of carbon.

Robert Ayers and Benjamin Warr in Accounting for growth: the role of physical work shows the graph shown as Figure 1 below.

Electricity prices and electrical demand
Figure 1. Electricity prices and electrical demand, USA 1900 - 1998 by Ayres – Warr

Ayres and Warr talk about the fact that falling electricity prices (due to improvement in technology and resulting efficiency) allowed the rapid growth of electricity. In discussing this phenomenon, they say:

. . .we also emphasize that several features of our work follow (albeit indirectly) from our concept of growth dynamics as a positive feedback cycle. This may not seem immediately relevant to our main results. But it is relevant to some of the choices we make later in formalizing the growth model. The generic positive feedback cycle, in economics, operates as follows: cheaper resource inputs, due to discoveries, economies of scale and experience (or learning-by-doing) enable tangible goods and intangible services to be produced and delivered at ever lower cost. This is another way of saying that resource flows are productive, which is our point of departure. Lower cost, in competitive markets, translates into lower prices for all products and services. Thanks to non-zero price elasticity, lower prices encourage higher demand. Since demand for final goods and services necessarily corresponds to the sum of factor payments, most of which go back to labor as wages and salaries, it follows that wages of labor tend to increase as output rises. This, in turn, stimulates the further substitution of natural resources, especially fossil fuels, and mechanical power produced from resource inputs, for human (and animal) labor. This continuing substitution drives further increases in scale, experience, learning and still lower costs.

When the economy starts encountering the reverse–higher real electricity prices–it seems like the “engine of growth” from lower prices suddenly goes into reverse, and becomes an engine of contraction. So higher prices for electricity, however well intended, whether from higher natural gas prices or renewables, or carbon capture and storage, seem likely to be recessionary. Current natural gas prices seem too low to be sustainable, given the huge costs (which is equivalent to low EROI) required for production. So some upward trend in electricity costs seems likely, contributing to recessionary trends. The reasons for the change may be necessary and worthwhile, but unfortunately, it doesn’t fix the likely outcome.

Of course, other things besides higher oil prices and higher electricity costs can also have a negative effect on the economy. We now have a huge government spending deficit, resulting in spending that greatly exceeds tax revenue. Raising taxes to fix this problem will be recessionary. To the extent that this deficit results from stimulus spending, this is really a follow-on effect of the earlier oil price spike, that had been covered up previously by the stimulus. If the higher taxes apply to oil and gas companies, the result could be lower production (because some resources which are not marginally profitable to produce will become unprofitable). This lower oil and gas production will also flow through the system, with likely negative economic impacts.

By. Gail Tverberg

Gail Tverberg is a writer and speaker about energy issues. She is especially known for her work with financial issues associated with peak oil. Prior to getting involved with energy issues, Ms. Tverberg worked as an actuarial consultant. This work involved performing insurance-related analyses and forecasts. Her personal blog is ourfiniteworld.com. She is also an editor of The Oil Drum.




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  • Anonymous on March 22 2011 said:
    Another superb paper by Gail Tverberg. And of course Professor James Hamilton is correct, as is an English economist at Warwick University - who's name I don't remember at this moment. The liars, fools and hypocrites are playing a dangerous game in Libya, because the cost of what they are doing could turn out to be much higher than the cost of maintaining a no-fly zone over northern Libya.Some game theory anybody? The goal should be to to protect civilians and keep the oil flowing. The point is to stop there, because when certain other things are added to that bottom line, an optimal solution might be impossible.

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