Oil Prices, Inflation & Recession
Oil Price Shocks Drive Interest Rates, Drag Economic Growth
May 15, 2008
Oil price shocks turn efficient markets upside down. Such was the case when the price of Persian Gulf crude went from $3.60 per barrel in 1972 to $37.42 in 1980, an increase of 1000% in 8 years. U.S. interest rates followed oil prices, slowing economic growth. The OPEC shocks of the mid-70s led to stagflation later in the decade and produced a full-blown global recession in the early 80s. (See charts.) Oil and interest rates then began a 15-year decline that bottomed out in 1998.
Stagflation Redux?
In 1998, oil sold for an average of $15.35 a barrel (expressed in 2007 dollars). Today, it is on its way to $150 and, on the not-so-distant horizon, $200. Today's price of around $130 represents a real increase of around 800% since 1998; $150 would be 1000%. This is a shock as severe as the 70s, and the effects are likely to be more widespread, in that:
- the world, in general, is more energy dependent today than it was 30 years ago;
- demand across the globe is growing rapidly;
- the US dollar is testing historic lows; and
- in the short term, there are few ready substitutes for gasoline, diesel fuel and heating oil.
Rising Inflation and Interest Rates Can Choke Growth
The consequences of the artificlal oil price increases of the 70s--OPEC flexing its muscles for the first time--lasted until the early 80s. Since 1950, the US economy has experienced only 7 years of negative economic growth. Four of those years occurred between 1973 and 1982.
Consumer price increases, in real terms, have averaged 3.9% since 1950. From 1973 through 1982, they rose by an average of 8.7%. In 1982, mortgage rates hit an all time high, and Art Buchwald, a columnist for the Washington Post, noted it was the first time ever that it was cheaper to borrow from the Mafia than from a bank.
Oil Prices May Have "Tipped"
Today's price increases are organic, and classic examples of "demand-pull" inflation. Demand for gasoline is inelastic, in that it is largely insensitive to price. Since 2000 the price of oil has quadrupled, yet demand has increased. US gasoline consumption in 2008 may, in fact, decrease compared with 2007, as American drivers are reacting visibly to $4.00 gas, unlike their relatively mild reaction when gas prices first hit $3.00 a gallon. How will American consumers react when gas hits $5.00 per gallon, as it inevitably will?
OPEC Has the World Over a Barrel
With a weak dollar, there is no reason to expect the markets to turn in the foreseeable future. More likely, it would appear, are additional outside shocks--ongoing unrest in the Middle East, or terrorism--that will likely spook oil markets. OPEC failed to maintain production limits in the 1980s due to a global recession and discord among member countries. In 2008, with global demand for energy at an all-time high, OPEC seems to be having little difficulty maintaining prices, production limits and relative harmony amongst its members..
Where Do Investors Go From Here?
It has been said that those who fail to study history are doomed to repeat it. In the absence of a sharp unexpected pullback in oil prices heading into 2009, the prudent investor would do well to make his near-term investment decisions assuming that conditions going forward will devolve in much the same way they did the last time similar shocks occurred.
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