Predicting the Future: The Link Between Crude Oil Prices and Recessions

http://www.southernlimitsnz.com/2012/04/prediction-is-messy-business-and-has.html

Prediction is a messy business at the best of times. It has a well known tendency to leave those with strong opinions on how the future will turn out looking silly when events inevitably play out completely differently. So for today's post, rather than make any outright claims to where things are heading I will instead point to a few indicators to look out for in the coming months and years that may have some bearing on global economic events. I am not an economist and I do not claim that the below graphs are in any way scientific. I do however have training in statistics and I believe there is enough crossover there to at least have some relevance to today's discussion.

In October 2008, former CIBC World Markets Chief Economist Jeff Rubin and current CIBC World Markets Senior Economist Peter Buchanan published a report arguing that high oil prices had caused the 2008 recession. They detailed how four out of the last five global recessions had been preceded by oil shocks (Figure 1). The 1973 Middle East War, the 1979 Iranian Revolution, the 1990 Iraq War and considerable decreases in OPEC production after the Asian Economic crisis in 2008 all lead to spikes in the price of oil. These spikes were then followed by a recession in what the IMF defines as advanced economies (North America, Western Europe and Japan). The IMF defines a global recession as 3 percent or less growth in the global economy and this is shown in Figure 1 by the horizontal red line. We can see that under this definition we are still essentially in a recession beginning back in 2007 with the U.S. Housing Bubble. Many mainstream commentators however are stating that the global economy is now recovering and back on track.

Figure 1: Crude oil prices, advanced economies GDP growth and recessions, 1970-2012. (1970-1981 crude oil prices Arabian Light from http://chartsbin.com/view/oau, March 1982-Febuary 2012 crude oil prices dated Brent http://www.indexmundi.com/commodities/?commodity=crude-oil-brent&months=360, March 2012 crude oil price Brent price from http://www.livemint.com/2012/04/04203155/Brent-crude-prices-rose-in-Mar.html. Advanced economies GDP growth from http://www.imf.org/external/pubs/ft/weo/2009/update/01/index.htm.

In order for economies to keep growing in our energy hungry world they need to consume more oil (energy) than they did the year before. As the price of oil grows it is necessary to spend more money just to consume the same amount of oil than they did before let alone increase the amount of oil consumed. This puts strain on the economy from the bottom up as citizens spend more of their income on filling up their vehicles than on consumption. In turn this puts pressure on companies that have decreased sales of consumer products, staff are laid off, and the newly unemployed find it impossible to find new jobs in a contracting market and can no longer afford to pay off car loan repayments, mortgages and other debts. It is a vicious feedback loop that continues until the market contracts enough that demand for oil drops. This leads to a drop in oil prices which in turn helps to fuel growth by providing (relatively) cheap energy.

The price of oil is of course not the only condition that causes a recession but it does seem to have an extraordinarily large impact on setting up the conditions for a recession to occur. Given that knowledge how does out current situation look? Are we heading for another economic contraction? If we compare the current oil price trends to those seen leading up to the last five recessions (not including the 1998 Asian economic crisis) we get some idea of what it takes to set up the conditions for a recession. This is not to say that if these conditions are met that a recession or economic contraction is  is inevitable but there is at the very least a fair chance that growth will slow.

Figure 2: Average percentage crude oil price increase from eighteen, twelve and six months before the peak crude price for each recession period. Dates in brackets represent the period surveyed. Middle East War and Iranian Revolution  crude oil prices Arabian Light from http://chartsbin.com/view/oau, all other crude oil prices dated Brent from http://www.indexmundi.com/commodities/?commodity=crude-oil-brent&months=360 except March 2012 crude oil price Brent price from http://www.livemint.com/2012/04/04203155/Brent-crude-prices-rose-in-Mar.html.

Figure 2 shows the huge average percentage price increases in crude oil that occurred in the eighteen months before each recession. For our current situation Brent crude prices increased 11% on average in the last six months. The Dot-com Bubble and the Housing Bubble saw a 16% and 17% rise respectively in the six months directly before oil prices peaked. It will be interesting to see what happens in the coming months if the six month average moves towards that 16% threshold. Brent crude would have to increase to US$133 per barrel for this to happen but it is not unlikely as sanctions on Iran begin to bite and other troubles in the Middle East flare up.

As I said at the beginning of this post economic soothsaying is a messy business and no one can ever predict how world events will unfold with any great confidence. I will update these figure as new average Brent  price data comes in and add new analyses as the months roll on.