How close a link is there between oil price shocks and recession?

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.

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.

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.

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.

My plans in the next few months

I need to cut back on my blog writing in the next few months because of other commitments. For one thing, I have signed a contract with Springer to write a short (125 page) book, tentatively called “Beyond Hubbert: How Limited Oil Supplies Cause Economic Crises.” David Murphy will be assisting me on this. The book is to be part of Prof. Charles Hall’s “Briefs in Energy” Series.

One of the reasons for writing up my findings this way is that it will make them more accessible to academic researchers. I will still have some ability to use excerpts online.

I also am giving some talks:

March 22 – Casualty Actuarial Society Ratemaking and Product Management Seminar – New Orleans – Mariott

April 16 – 2011 Biophysical Economics Seminar, SUNY-ESF – Syracuse, NY (Contact biophysicalecon at gmail.com for information. Starts April 15.)

May 7 – Peak Oil: fact or fiction – Barbasro, Spain

May 12 or 13 – China University of Petroleum – Beijing, China

With these commitments, I am afraid I will have less time for writing on Our Finite World, for a while. I hope to still write some posts. It may be that I can post some of my writings and talks on Our Finite World. None of these are demanding exclusivity.

List of Some Prior Economic Writings

On a blog, it is sometimes a little hard to find prior posts. These are a few links to posts giving some of my economic views:

How much oil will be recoverable?

WSJ, Financial Times Raise Issue of Oil Prices Causing Recession – Summary of some issues

There is No Steady State Economy (except at a very basic level)

How is an oil shortage like a missing cup of flour?

Clean energy won’t save the world!

The Oil – Employment Link, Part 1

Delusions of Finance: Why most models are wrong – Overview type post

Peak Oil and the Continuing Financial Crisis – Informal write up of talk in Barcelona, Spain in October 2010

There is plenty of oil, but . . . – Overview type post

Is it possible to raise taxes enough to fix the deficit? What does the oil connection say?

About Gail Tverberg

My name is Gail Tverberg. I am an actuary interested in finite world issues - oil depletion, natural gas depletion, water shortages, and climate change. Oil limits look very different from what most expect, with high prices leading to recession, and low prices leading to inadequate supply.
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9 Responses to How close a link is there between oil price shocks and recession?

  1. Jan Steinman says:

    Thanks for another excellent post! Although I thought the energy-recession link was obvious and “common knowledge,” it’s good to see the references and data.

    “We haven’t had a significant enough electricity price spike to test this theory.”

    We may soon have a test case: BC Hydro has announced increases in electricity prices of about 50% over the next three years, which should be enough to cause a recession if the “energy –> economy” correlation holds true for electricity.

    They claim to need this in order to replace aging infrastructure, but they’ve come under fire for a $1 billion program to install “smart meters,” ironically sold to the public for their ability to conserve electricity and keep the cost down.

    Another part of this is planning for conversion of the transportation sector to electricity, and yet another part is a recent huge increase in “public-private partnerships,” in which medium-scale “run of river” power production by private interests is being encouraged through above-market rate incentives and other subsidies.

    BC Hydro is a “crown corporation.” It’s an independent company, wholly owned by the province of BC, rather than an actual component of provincial government. In recent years, much of the provincial capital infrastructure has been re-organized into crown corporations, in preparation for selling them off to the private sector. And you thought Canada was a socialist country!

    However, our brand-new Premier (Christy Clark) wants to review these rate increase.

    Personally, I think cheap electricity (under $0.10 per kWh) from non-carbon sources (over 90% hydropower) is a huge economic driver here. We’ll see…

    • Smart meters seem particularly iffy. If a utility messes up on them, there could be real security issues, and even problems with delivering electricity. Businesses that can easily time shift are already getting different day-night rates, and some get discounts for permitting cutoff in shortages. How much homeowners can /will do in addition is very iffy. If the problem is use at a certain time of day, it would seem to make more sense to have rates (announced in advance) that vary by the time of day, so people can plan their use ahead of time. To get real savings, the utility would need the ability to cut off people’s heat and air conditioning. I am not sure people will want this. Also, the cost would likely be more than just smart meters–there would need to be a hook-up and controls with the heat and air conditioning.

      • Jan Steinman says:

        I was amazed to learn that smart meters use cell phone technology! I don’t have a cell phone, and don’t particularly want one on the premises.

        They already have a wire leading right to the meter — why the heck can’t they use Broadband over Power Line (BPL) technology to communicate with the meter?

        As an RF Engineer, this strikes me as an inefficient, wasteful method of communicating that consumes a non-renewable resource (radio spectrum) and exposes us all to more electromagnetic radiation.

        (Not that I’m a huge believer in significant health risks from EMF exposure, but it seems like yet another case for the Precautionary Principle.)

        I’m also not a big fan of letting the phone company cut off my electricity via a phone call. A cop would have to get a subpoena, signed by a judge, to do the same thing. If it’s important enough, let them send a lineman out!

  2. George Mobus says:

    Gail,

    I was inspired by David’s graph (Further Evidence of the Influence of Energy on the U.S. Economy, Fig. 2) showing oil price, GDP, and percent of GDP in petroleum changes year-over-year, so I wrote this: Its the area under the curve.

    What I noticed looks like a correlation between the area under the curve of price changes and a lagging economic impact. In other words it isn’t so much the spike that causes the problem, unless it is really dramatic, but the amount of time that the price remains above some critical point. You can almost see the buildup effect and then some peak event which triggers the on-set of economic decline (not yet recession but a decline in the growth of GDP). Furthermore, the buildup of total energy cost (for oil anyway) always leads the economic impact so this implies strongly a causal relation.

    David and Charlie had already done some work to show that prices over $85 (real) would have a dragging effect on the economy. My own model based on the physics of exergy flow and economic work shows a direct relationship between the net energy available to do economic work and real wealth creation. Assuming there is still some basic connection between real wealth and economic indicators (a hard assumption to back up these days with so much debt and phony money circulating) it isn’t hard to imagine the impact of reduced energy flows on the economy.

    George
    PS. Looking forward to seeing you at BPE!

    • George- That is a really good point about the area under the curve being what causes the problem. It is really a combination of price and time (also how much the economy is using of these things.

      See you at BPE! I am even planning on staying over until Sunday.

  3. Bicycle Dave says:

    Hi Gail,

    I always look forward to your posts and will miss seeing them as often – good thing the biking season is upon us here in the often frozen north-land and I have a different enjoyable distraction!

    Actually, I’m glad to hear that you are writing a book. Hopefully, this will be something I can recommend to people who are looking for both the broad picture and yet enough detail to make a solid case. Hopefully, your book will cover these key points:

    1. A very factual analysis of current production, spare capacity, proven reserves, potential reserves and the magical “undiscovered” reserves. I realize that actual facts for these categories are often scarce to non-existent. But, I trust that you can sort this out in the best possible manner. We need a good presentation of the depletion picture that is easy to understand by average folks.

    2. How declining oil production will impact our economy and the lifestyle of western nations. In particular our population level, car culture, food supply, and other creature comforts (like a warm house in the winter).

    3. Why technology advances are unlikely to maintain our current western lifestyle. Why our faith in “the human spirit” to conquer any challenge with innovation and hard work, is mostly a delusion.

    4. Potential scenarios – how things are likely to play out over time as shortages arise. I would not waste time on “pie-in-the-sky” scenarios based upon some global epiphany wherein all nations decide to cooperate in the most rational fashion possible. Nor would I spend much ink on the local “Transition Towns” kind of movements. What mostly interests me is whether the power-down in likely to occur slowly over time (slow emergency) or reach a tipping point that results in a more drastic collapse.

    Just a few thoughts – if this is not the direction of your book, perhaps some ideas for a future book.

    Thanks for all the good essays on this blog.

    • The current book is somewhat narrowly focused, and is aimed more at a university audience. Springer is mostly a college text book company, but these books are smaller books that universities can use as supplementary texts. They hope to sell them to universities as part of a package, with the idea that the university can make all of the books in the package available for students to use free of charge, mostly through downloads, and also by checking them out of the library. In addition, the book will also be available through Amazon (and perhaps other sources–I don’t know). I can also put content from the book up on my web site.

      The chapters at this time are

      1. Hubbert’s Model – Why it doesn’t take us far enough
      2. Why reduced oil consumption leads to lower economic growth or contraction
      3. OECD is already reaching oil limits
      4. Oil prices don’t rise without limit; an oil glut may arise form high-priced (low EROEI) oil
      5. Growth in oil supplies enables wider use of debt; contraction limits use of debt
      6. Economic growth enables rising real estate prices, rising stock prices, and other desirable outcomes
      7. Direct evidence suggesting a connection between oil limits and the 2008-2009 recession
      8. The expected impact of limited oil supply on alternatives
      9. The expected impact of limited oil supply on efficiency improvements
      10. Planning for a worrisome future

  4. Ikonoclast says:

    In addition to Bicycle Dave’s suggestions you might want to look at possible relative national economic power shifts. Of course, a catastrophic and chaotic collapse worldwide might mean no consistent picture emerges at all.

    A Paul Kennedy (Rise and Fall of the Great Powers) style analysis of expected relative changes in national economic power could be made in at least a tentative manner. To give a minor example:

    Will Australia fare better than Canada? Canada has much higher energy consumption per capita than Australia. Presumably much of this is driven by heating demand in a very cold climate. In Australia, it is possible to live just about anywhere in the country without any heating or cooling. At times it might be very uncomfortable, but heating and cooling are not life and death issues in most inhabited areas of Australia.

    Australia has poor and declining oil production. However, coal and gas production are very high. (Much is exported at present.) Canada has good oil reserves but the tar sands are low EROEI and very polluting. Australia has enormous solar potential and long coasts for onshore wind generation. Canada might have high wind potential but mediocre solar potential?

    If Canada seeks to keep its oil for itself would the US tolerate that? If Australia sought to keep its gas for itself would China tolerate that? Australia could convert its car fleet to run on gas and use gas to replace gasoline (petrol) imports.

    There are certainly many permutations and combinations at regional and national levels. Australia has the hot, arid empty space necessary to completely power itself by solar power. This is of course dependent on the infrastructre being feasible (to collect his relatively diffuse energy source).

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