Due to the lack of trumpeters, the end of the world has been postponed for three weeks
There is a large and expanding economic literature that seeks to explain why the steep oil price rise since 2003 has not led to a recession. The common conclusion, arrived at by different models and analysis methods, is that the U.S. economy is now mostly immune to oil prices hikes and has been so since the mid-80's. Peak oil proponents assume a simple model of the relation between oil supply or price shocks and economic performance. Economists have called into question some aspects of that model. Those studying peak oil need to make cogent responses to ensure that their view is taken seriously. It is beyond the scope of this column to do a detailed analysis, but it is possible to lay out some of the current debate and the issues that need to be addressed.
Peak Oil Economics
Peak oil economics is largely based on hypotheses presented in the Hirsch report.1 The basic model asserts that global oil supply disruptions create price shocks which lead, in turn, to recessions. (See pp. 26-32 of the report.) The first graph (left) shows supply shortfalls since 1954. The second graph (below left) shows the historical relationship between oil prices and U.S. recessions since 1969. Hirsch et. al. explain that "oil price increases have preceded most U.S.recessions since 1969, and virtually every serious oil price shock was followed by a recession. Thus, while oil price spikes may not be necessary to trigger a recession in the U.S., they have proven to be sufficient over the past 30 years."
The oil price shock of 2003-2007 has not caused a recession in the U.S. Thus the correlation cited by the Hirsch report is contradicted in the recent period. The supposition that oil price shocks lead to recessions was first explored in various works of Professor James Hamilton of the University of California, San Diego. Hamilton's work is referenced in San Francisco Reserve Bank's 2005 study Why Hasn't the Jump in Oil Prices Led to a Recession? and is cited, along with other sources, in the Hirsch report.
Current Economic Conditions
Before discussing the arguments made in more recent economics papers, it is useful to review the economic conditions relating to oil that exist today.
- Oil prices nearing $100 a barrel are just now close to the inflation-adjusted levels of the 1970's and early 80's oil supply shocks. See the price graph at Hamilton's Econbrowser article $90 a barrel: Is it time to start worrying about the oil price shock of 2007?
- Energy expenditures as a percentage of household income is moving toward levels last seen in the 1970's and early 80's, but have not reached those levels yet in the U.S. See Not Fixing to Walk, this column, October 21, 2007.
- The recent oil price shock is said to be "demand-driven". There has been no supply shock in the 2003-2007 period except for that caused by the American invasion of Iraq. The global oil supply according to the EIA supply data has been a bumpy plateau ranging between 83.9 and 85.5 million barrels per day since the beginning of 2005. See The Perfect Storm, this column, October 31, 2007. There have been local exogenous shocks e.g. in the Niger Delta, or the Gulf of Mexico following Katrina and Rita, but these have not led to a significant sustained percentage drop in global supply. Production declines in regions like the North Sea and Mexico have been made up elsewhere so far.
- Oil expenditures as a percentage of U.S. GDP are nearing levels last seen in the 1970's and early 80's according to Paul Segal's Why Do Oil Price Shocks No Longer Shock? (Oxford Institute for Energy Studies, October, 2007). The excerpt below and accompanying graph is from page 19 of Segal's new study. The graph shows petroleum expenditures as a share of GDP (percent) from 1970 to the present.
Taking the average of the three years leading up the shock and comparing it with the level at the peak of the shock, the rise in petroleum expenditure as a share of GDP was 3.2 percent to 1974 and 3.6 percent to 1979. The rise from the average over 2001–03 compared to 2006 is 2.3 percent; if we assume that the average oil price for 2007 will be $80 then the rise will have reached 3.3 percent. Thus on this measure we have only just reached the level of increase in oil costs that were experienced in the 1970s. [emphasis added]
Summarizing the situation as we approach 2008, the ongoing oil price shock has occurred in a context of strong global demand since 2003, and flat supply since 2005. GDP has been growing on average 3.27% per year during the 2003-2007 period. Sharply rising oil prices in these circumstances implies a very low short-run price elasticity of oil demand reflecting results reported in the University of California (Davis) study Evidence of a Shift in the Short-Run Price Elasticity of Gasoline Demand. Unlike the big prices shocks of the 1970's and early 80's, the world is enduring a demand shock in which oil prices alone have not affected economic growth.
The current run-up in oil prices during a surging economy appears to have no historical precedent. In the absence of supply significant shocks, and as oil prices, household expenditures on energy, and share of GDP taken up by oil expenditures rise toward or match levels last seen in 1970's and early 80's, the world is entering uncharted water.
Views of the Economists
Hamilton updated his views in Oil and the Macroeconomy (August, 2005), stating the basic problem and his observations at that time. His paper is quoted at some length here—
Nine out of ten of the U.S. recessions since World War II were preceded by a spike up in oil prices. One way to inquire whether this might be just a coincidence is with a statistical regression of real GDP growth rates (quoted at a quarterly rate) on lagged changes in GDP growth rates and lagged logarithmic changes in nominal oil prices... (p. 1)
If one estimates a log linear relation between GDP growth and lagged oil prices, the statistical significance of the relation falls as one adds more data (Hooker, 1996), suggesting at a minimum that a linear relation is either misspecified or unstable... The size of the effect [oil price shocks on GDP] is substantially smaller as well— whereas the 1949-80 regression would predict that GDP growth would be 2.9% slower (at an annual rate) four quarters after a 10% oil price hike, the 1949-2005 regression would predict only 0.7% slower growth... (p. 7)
As noted by Kilian (2005), civil unrest in Venezuela in December 2002 led to a drop in production of 2.3 million barrels a day, representing 3.4% of world production at the time. The net oil price series ... reflected a surge in crude oil prices 20% above their previous 3-year high. Nevertheless, there was no discernible drop in GDP. Another surge in [oil prices] of 18% occurred in 2004:III [3rd quarter], accompanied by a 1.3% increase in world production, and a third surge of 21% in 2005:I, accompanied by a 0.2% increase in production, with no recession as of the time of this writing... [and below, pp. 9-10]
It is clear from the last two examples in particular that demand increases rather than supply reductions have been the primary factor driving oil prices over the last several years. Insofar as these demand increases resulted from global income growth, one wouldn’t expect to see the sharp drop in consumer spending on other key items that accompanied the episodes in Table 1 [see the document]. At a minimum, the failure of a recession to result as of the time of this writing from the oil price increases of 2003-2005 suggests that there is not simply a mechanical relation, even a nonlinear one, between oil prices and output. The experience is consistent with the claim that the key mechanism whereby oil shocks affect the economy is through a disruption in spending by consumers and firms on other goods and that, if this disruption fails to occur, the effects on the economy are indeed governed by the factor share argument [oil expenditures as a share of GDP] [emphasis added]
Demand increases, not supply reductions, have been the main driver of the 2003-2007 oil price shock. Hamilton wrote this in 2005, and there is still no recession as 2007 winds down. Consumer spending, which makes up about 70% of U.S. GDP, has remained strong during the price run-up. Since consumer expenditures have not been curtailed, Hamilton surmises that there has been no recession because oil expenditures as a percent share of total GDP remains low, or at least below levels seen in the 1970's and early 80's. This "factor share" is now going up, as noted above.
Here is a partial list of recent academic studies or web articles
that claim that oil price shocks alone are not sufficient to cause
economies to tip over into recession. Some of these are referenced in
Hamilton's recent Econbrowser story cited above, others are not.
1. Why Do Oil Prices No Longer Shock? — Paul Segal
2. The Macroeconomic Effects of Oil Price Shocks: Why are the 2000s so different
from the 1970s — Olivier J. Blanchard and Jordi Gali
3. Declining Effects of Oil-price Shocks — Munechika Katayama
4. The Economic Effects of Recent Increases in Energy Prices — Congressional Budget Office
5. Not All Oil Price Shocks Are Alike: Disentangling Demand and Supply Shocks in the Crude Oil Market — Lutz Kilian
6. Be Not Afraid — Jerry Taylor and Peter VanDoren
The Segal (2007) paper (link op. cit.) provides a literature survey of economic studies, including Hamilton's original studies and some of the ones listed above, so we will start with the main results reported there and then present the conclusions of other works. Segal's historical literature survey and discussion supports these key findings—
We also saw, however, high oil prices have had no perceptible impact on the macroeconomy over the last few years, and that in the data oil price rises already stopped having an impact [on GDP] some time in the 1980s. At the same time, oil price rises stopped passing through to inflation, and this may hold the explanation: if oil price rises do not raise prices, then interest rates do not need to respond to them, and the impact on aggregate activity may therefore be minimal. (p. 22)
The Blanchard and Gali study explains the recent failure of higher oil prices to lead to recession as follows—
We examine four different hypotheses for the mild effects on inflation and economic activity of the recent increase in the price of oil: (a) good luck (i.e. lack of concurrent adverse shocks), (b) smaller share of oil in production, (c) more flexible labor markets, and (d) improvements in monetary policy. We conclude that all four have played an important role.
Two conclusions clearly emerge from this analysis: First, there were indeed other adverse shocks at work in the 1970s; the price of oil explains only part of the stagflation episodes of the 1970s. Second, and importantly, the effects of a given change in the price of oil have changed substantially over time. Our estimates point to much larger effects of oil price shocks on inflation and activity in the early part of the sample, i.e. the one that includes the two oil shock episodes of the 1970s.
Our basic empirical findings are summarized graphically in Figure 1 [shown left]. The left-hand graph shows the responses of U.S. (log) GDP and the (log) CPI to a 10 percent increase in the price of oil, estimated using pre-1984 data. The right-hand graph displays the corresponding responses, based on post-1984 data. As the Figure makes clear, the response of both variables has become more muted in the more recent period. As we show below, that pattern can also be observed for other variables (prices and quantities) and many (though not all) other countries considered. In sum, the evidence suggests that economies face an improved trade-off in the more recent period, in the face of oil price shocks of a similar magnitude.
Segal, Blanchard and Gali share the point of view that the structure of the economy is now different than it was in the 1970's in so far as the effects of oil price shocks on GDP is more "muted". They cite various factors, including the lack of a contribution to core inflation, more flexible labor markets and greater efficiency of oil use in the economy. Lutz Kilian goes even further—
One of my key findings is that no two oil price shocks are alike. Nevertheless, there are some regularities. All the major real oil price increases since the mid-1970s can be traced to increased global aggregate demand and/or increases in oil-specific demand. The latter demand shifts are consistent with sharp increases in precautionary demand in the wake of exogenous political events in the Middle East. In contrast, disruptions of crude oil production play a less important role, suggesting that the traditional approach of linking oil price increases to exogenous shortfalls in crude oil production must be re-thought. The most recent build-up in the real price of oil, in particular, can be attributed almost entirely to positive global aggregate demand shocks. Moreover, when political events do affect oil prices, as during the Persian Gulf War, for example, my analysis suggests that it is less the actual physical supply disruptions than the increased precautionary demand for oil triggered by fears about future oil supply shortfalls (which may or may not be realized) that is driving the price of oil. [emphasis added]
Reading The Economic Impact of Oil Supply Shocks on the G7 Countries (Killian, 2006), it is evident that his analysis completely contradicts the Hirsch report's views on endogenous oil supply shocks, even those of the 1970's and early 80's. Hirsch et. al. state that "for purposes of this study, the 1973-74 and 1979 disruptions are taken as the most relevant, because they are believed to offer the best insights into what might occur when world oil production peaks." Killian asserts that "The 1973/74 oil supply shock did not play a major role in the 1974/75 recession."
In the contrarian cases listed here, economists have sought to divorce oil price shocks, in part or in whole, and regardless of whether they are supply or demand driven, with subsequent recessions.
Discussion from a Peak Oil Perspective
Peak oil theorists assume without question that oil price shocks, especially if these are due to major supply disruptions, lead to recessions. In the 2003-2007 period, a price shock caused by strong demand has not led to a recession. Here are some relevant considerations for thinking about the problem.
- The oil supply has been a bumpy plateau since January of 2005. This may be the permanent global peak of production, a condition that some plausible supply scenarios suggest could last many years. Production might even remain in a more flexible 82-87 million barrels per day range for another decade or so, depending on demand levels set by price and productive capacity. We must also think about the price inelasticity of oil demand in this context.
- If these economic studies are correct that oil price shocks do not alone inhibit GDP growth, and in the absence of a large endogenous supply shock in the Middle East or elsewhere, the U.S. economy could muddle through the coming decade at various levels of GDP growth. If a recession does occur soon, this will likely be due to conditions that curtail consumer spending such as the credit crunch following the collapse of the housing bubble, with rising oil prices and expenditures serving as an important contributing—not the sole—factor.
- A monotonic, perhaps exponential, decrease in global oil production over several consecutive number of years, signaling that the bumpy plateau period is over, will cause the kind of supply shock that peak oil theorists believe will lead inexorably to shrinking economies (measured by GDP) and great human distress. Unlike previous oil (supply or price) shocks, oil shortages on the world market would be a permanent, not a temporary condition. It is this case, where no growth in the oil supply is possible, that the resiliency of industrial economies will be put to the test.
Contrarian economist Paul Sobel concludes like this—
It was also shown that the oil price has only just (as of late 2007) reached the magnitude of the shocks of the 1970s, in terms of total direct cost to the economy. While this may mean that the harm to the global macroeconomy is just around the corner, the existing empirical research would suggest otherwise.
One wonders if there is any oil price at which Sobel thinks that harm to the global macroeconomy will occur. In the case of peak oil (point #3 above), oil prices can only go up unless demand, including oil demand replaced by substitutes, matches or falls below yearly production declines. No doubt Sobel has not considered the peak oil scenario. Rest assured, there are oil prices high enough to harm the global macroeconomy.
Many of those concerned about peak oil take their economic assumptions—naively, peak followed by collapse—as axiomatic. So-called "doomers" assume the worst, but they have not done all of their homework. Peak oil theorists or commentators often ignore the economic literature that discusses the complex relationship between GDP growth and the oil markets. They do so at their peril. By default, the oil supply and price is seen as the single overwhelming determinant of economic performance. This simple model is belied by the demand-driven price shock of the 2003-2007 period. Many economists have also been taken by surprise, and they are scrambling around to come up with explanations.
Many of those studying peak oil need to develop well thought-out scenarios that include models of future economic activity based on their oil supply projections instead of running around telling everybody the sky is falling. The good news is that there may be time to develop such scenarios and implement solutions, like a robust national railroad system, that make sense. Time will tell.
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1. Peaking of World Oil Production: Impacts, Mitigation and Risk Management, by Robert L. Hirsch, SAIC, Project Leader, Roger Bezdek, MISI and Robert Wendling, MISI, February 2005.