Research & Advice

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Oil Shocks and the Economy

Sunday, March 13, 2011

 

  • The US economy has become less energy-sensitive due to increased use of coal & renewable sources, as well as a decline in output-share of manufacturing.

  • Oil’s impact on inflation has diminished significantly, particularly over the last decade, as rents and housing have grown larger.

 

The most famed oil shocks of the last sixty years were related to Middle East affairs – the 1956 Suez Crisis, the 1973 Arab Oil Embargo, the Iranian Revolution of 1979, the Iran/Iraq War of 1980, and the Persian Gulf Wars of 1990 and 2002. At some point in the not too distant future, we will likely add the 2011 Tunisia/Egypt/Libya revolutions to that list.

Of course, not all oil shocks are related to Middle East supply disruptions. Some are just reactions to extremely oversold conditions. Other oil shocks are due to strong economic tailwinds, such as the 2007-2008 surge led by emerging market demand.

Regardless of how oil shocks are triggered, there is an impact to the economy. How much of an impact is an important conversation as it helps Berkshire Money Management identify the potential damage to the economy and thus the stock markets.

Although some economists (and many non-economists with economic opinions) are concerned that higher oil prices will stall economic growth, if not push the US economy into recession, BMM currently believes those fears are unjustified, based in part on the relationship between economic growth and the price of oil.

BMM projects that every ten percent rise in the price of oil corresponds to a 0.2 percent point reduction in economic growth one year later. This correlation is less than decades passed (such as during the 1973 Arab Oil Embargo) because the economy has become less energy-sensitive than it used to be; energy use per capita has declined. In 1981, 8.1% of our disposable personal income was spent on energy. Today that is down to 5.3%. As a result, every ten percent increase in oil prices translates into less than 0.1 percentage point increase in our share of income going to energy.

Bottom Line: A price increase of any consumable has the potential to crowd out potential purchases of other goods and/or services. Some demand destruction from an oil price shock should be expected, but the damage is currently expected to be minimal compared to previous oil price shocks. Thus, the US economy is not expected to slip back into recession in 2011.

Noteworthy, but not necessarily related to the topic of oil shocks, is that the stock market has gone more than twice as long as normal without a 5% correction. A 5% drop would bring the market back to its January lows, and that would be a normal and regular retreat for the stock market. Historically, a 5% correction from an intermediate-term top should be expected, on average, three-and-a-half times per calendar year. At this point, it would be imprudent to correlate stock price drops to anything other than normal, regular market action.