The relation between oil prices and economic activity

Published on Real-World Economics Review Blog, by Lewis L. Smith, August 27, 2010.

… The relationship between oil and economics is a paradoxical one.

On one hand, the production functions used by most economic theories are net of purchased inputs, so energy in any of its many and varied forms is nowhere to be found. Moreover, until 1973, coal, natural gas and oil were so cheap and the long-run supplies believed to be so abundant that their future hardly seemed worth worrying about. In fact, both Saudi Arabia and the oil industry continued to propagate the myth of this country as a cornucopia of crude oil right through 2004. 

[This "balloon" was "punctured" in 2008 by none other than the King of Saudi Arabia and top officials of Saudi-Aramco, the national oil enterprise. He said in effect that future discoveries will be for the Saudi children and not (by implication) for your SUV ! And the top officials said that Saudi production will peak within a few years.]

On the other hand, since 1973, the impact of fluctuations in oil prices on the rhythm of economic activity [and vice versa] has been impossible to ignore. So in the arena of applied economics, the interaction between the two has generated a large literature among economists and other concerned professionals, some of which is contradictory and/or acrimonious !

In addition, the debate is complicated by issues of methodology as well as of substance … //

… My impression of the present status of the debate over oil prices and economic activity is as follows  —

[1] Frequently there is a relationship, albeit a complicated one.

[2] Causality can run in either direction. That is, an oil-price spike can help to bring on a recession, but a prolonged period of economic growth can provoke an increase in oil prices, as happened with the run-up which ended with WTI at $147 per barrel in 2008.

In the latter case, the principal “drivers” seem to have been the following:
[a] A history of prolonged economic growth in many countries.

[b] Anticipations of continued strong growth by both the Chinese and the Indian economies, regardless of what might happen elsewhere.

[c] Failure to anticipate the financial crisis which brought on the Great Recession.

[Aside —  Since my second son and one of my nephews are the fifth generation of my mother's family who work in the construction and housing industries, I believe that this crisis was foreseeable and preventable (without consulting an economist). But that is a story for another day !]

[3] When changes in oil prices do impact the economy more than vice versa, the impact is frequently asymmetrical and nonlinear. That is, a dollar-per-barrel increase at one time will not have same impact [in an opposite direction] as a dollar-per-barrel decrease at another. Metaphorically speaking, what goes up does not always come down the same way.

[4] In any one situation, there is no one explanation of what happened. Typically there are several, with one predominating, and feedbacks complicating our interpretation of events at every turn. Supply and demand are almost always present, but they seldom tell the whole story.

Having hopefully answered the question, I would like to add that it is often much harder to forecast demand, prices and supply for the oil industry than it is for most other industries.

This situation is partly due to [1] through [4] above. However, there are other factors. The “bottom line” seems to be that the oil industry is rather different from most other industries and different in important ways: … (full long text).

Comments are closed.