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Will the Price of Oil Cause a Recession?

EV World's contributing cultural economist examines the potential impact of high oil prices on the U.S. economy.

By Ronald Cooke

Introduction

Although the world economy continues to grow, the economic health of the United States is at risk. There are several potential problems. In this short essay we examine how the price of oil impacts our economy, and conclude a recession is highly probable. If America does experience a recession, or even a period of declining GDP, the resulting economic malaise will spread to all of its trading partners.

That’s one of the “benefits” of globalization.

The Oil Factor

In 2006, the United States consumed an estimated 20,700,000 Bl of oil a day, or approximately 7,555,500,000 barrels of oil for the entire year. That’s the equivalent of 65.3 barrels of oil for each and every one of the 115,677,000 households in America. The bill for refined oil products, such as gasoline, diesel, and heating oil fuels, along with the consumption of refined oil as a material used in the manufacture of other products, now exceeds $ 860 billion per year (about 6.5 % of GDP).

In the following chart, the world price per barrel for oil has been plotted against America’s annual average oil consumption per household. Oil is purchased as a refined product by consumers (gasoline, diesel, propane and heating oil fuels, etc.), and by manufacturers who use it as a feedstock or in the processing of other products (plastics, cosmetics, pharmaceuticals, etc.). This chart shows it took roughly four years for consumption to decline after the price shock of 1979. On the other hand, the price reduction of 1986 and the lower prices of 1986 through 1999 encouraged only a marginal increase in consumption. The price increases of 2000, 2004 and 2005 have yet to cause any significant change in oil consumption.

Thus, on a per capita and on a per household basis, oil consumption has been relatively inelastic since 1986. (For a discussion of elasticity see “The Elasticity of Oil Production and Consumption” . At this point in history, it will take a significant recession, an incredible shift of consumption to alternative fuels, or a deep transformation of lifestyle to bring down oil consumption.

The relationship between oil consumption, expenditures and recessions has been graphed in the chart below. Significant increases in the amount of money America spends on oil (1973, 1979, 1990 and 2000) have been followed by a recession. Yes. Other factors contributed to the decline in GDP that characterized these recessions. However, one can not escape a nagging fear that sharp increases in oil expenditures may cause a subsequent recession. The huge increases that occurred in 2004 and 2005 suggest the possibility of a coming recession in the 2007/2008 timeframe.

Sharp, sudden, increases in foreign oil purchases are not only inflationary (because they contribute to the devaluation of the dollar), they often mirror subsequent decreases in GDP growth. In the following chart we adjust annual GDP growth for inflation and then compare GDP growth with U. S. foreign oil purchases per person and periods of recession. The key point of this chart is the huge increase in foreign oil purchases that occurred in 2004 and 2005. These patterns suggest a possible decline in GDP growth in the 2007 to 2008 timeframe. If history is any guide, GDP growth is likely to turn negative.

Historically, there has been a good correlation between U. S. oil purchases per person and the rate of inflation. Although there was a lag to the increase leading up to the 1974 recession, spending more on oil has always meant higher inflation (see “Will Higher Oil Prices Fuel Inflation?” for this discussion). The real puzzle? Why have we not seen a comparable – or even greater – increase in the rate of inflation during this cycle? This chart suggests a period of much higher inflation is just around the corner.

When constructing and analyzing charts like these, there is always the possibility of making a mistake in the process of data collection or analysis. But higher oil prices appear to have introduced additional risk into our economic outlook.

Conclusion

Given the evidence, the odds of oil playing a role in either triggering or exacerbating a worldwide recession before the end of 2008 are very high.

Author's caveat: As usual, this essay is presented without any warranty what-so-ever.

The complete essay “Warning: Recession Ahead” includes data and analysis on debt, real estate and oil as contributing factors to a possible recession. It may be found at http://www.theculturaleconomistblog.blogspot.com/.

Times Article Viewed: 12715
Published: 20-Jun-2007

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