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Do plummeting oil prices indicate a coming global recession?

Stephen Nowers illustration

ANALYSIS: Are lower oil prices good news? Not really, if it means the world is sinking into recession.

We know from recent experience and common sense that high oil prices are a drag on oil importing economies, because more money spent on the same amount of oil leaves less to spend on discretionary goods and services. In addition, oil money sent to oil exporting countries is likely to be spent within those economies, rather than being reinvested in the oil importing country.

A rough calculation indicates that the combination of European Union countries, the United States and Japan spent a little over $1 trillion dollars in oil imports in 2011, roughly the same amount as in 2008. Governments have been running up huge deficits and have been keeping interest rates very low to cover up this damage, but it is hard to make this strategy work. The deficit soon becomes unmanageable, as several European countries have recently discovered. The U.S. government is facing automatic spending cuts as of Jan. 2, 2013, because of its continuing deficits.

Furthermore, lower interest rates aren’t entirely beneficial. With low interest rates, pension funds need much larger employer contributions if they are to make good on their promises. Retirees who depend on interest income to supplement Social Security find themselves with less income. The lower interest rates don’t necessarily stimulate the economy, either, if buyers don’t have sufficient discretionary income.

Here are a few reasons why low oil prices may be a signal that the world is headed for deep recession.

Oil supply not rising enough

The big issue is that oil supply is not rising enough -- and hasn’t been for a long time. When oil supply doesn’t rise fast enough, two opposite effects can take place:

  • Prices will go higher. This can be seen in the upward trend in prices in the last eight years.
  • Prices can drop quite sharply, as they did in late 2008. This happens when parts of the world are entering recession, and their demand decreases.

This second effect may be happening this time around. The downturn we are seeing in prices may have farther to go as the recession plays out.

Problem area: Oil consumption declining

There is a close correlation between oil growth, energy growth, and gross domestic product (GDP) growth. In recent years, a growth (or drop) in energy use seems to proceed a growth (or drop) in a country’s GDP. Recently, oil consumption has been declining sharply, which could signal further economic contraction.

Furthermore, data from the Joint Organizations Data Initiative (JODI) shows that oil demand in Portugal, Italy, Greece and Spain is down even more -- about 10 percent in one year. This would suggest that these countries are sliding deeply into recession.

US consumption also shrinking

U.S. oil consumption is also shrinking -- down 3.2 percent the first four months of 2012 compared to the same period in 2011. This looks like a repeat of the pattern that took place in 2005 to 2009. Oil consumption was stable through 2007, then dropped in early 2008 by an amount not too different from the decrease in oil consumption from 2011 to 2012. The bigger step-down in oil consumption came in 2009, after oil prices dropped, and the follow-on effects (reduced credit availability, layoffs) had started. Now oil consumption has been relatively stable in 2009 to 2011, but there has been a step down in consumption in 2012, similar to 2008.

Not all oil is economic

Oil prices make a difference in a company’s willingness to drill new wells. For example, oil sands production in Canada is believed not to be economic if prices slip below $80 barrel. In most cases, existing production will continue, but new production will stop. There are quite a few other types of oil extraction elsewhere (for example, arctic extraction, new very small fields, very deep oil wells) that may not be economic at lower prices.

Saudi Arabia makes frequent statements about adjusting its production to keep prices down. But a closer look at Saudi Arabia’s production pattern over the past few years shows Saudi production has been highest when oil prices are highest. Production drops as prices drop. As oil prices drop this time around, we can expect Saudi Arabia and others to find excuses to save production until prices move higher.

Countries exporting oil depend on the revenue, plus taxes on this revenue, to help support their budgets. As oil prices drop, governments find themselves with less money to fund public welfare programs. This dynamic can cause lower oil prices to lead to political instability in some oil exporting nations.

Thus, any drop in oil prices tends to be self-correcting. But that doesn’t happen until oil production drops, prices of other commodities drop, and many workers are laid off. We saw in 2008-2009 that this kind of recession can be very disruptive.

What’s ahead?

We can’t know for certain, but the big issue is chain reactions in an interconnected international economy.

A country that appears to be near default is likely to face higher interest rates, making its cost of borrowing higher. The higher interest costs, by themselves, push the country closer to default.

One of the issues with high oil prices is that the higher prices, especially among oil importers, give rise to a kind of systemic risk that affects many kinds of businesses simultaneously. High oil prices tend to do several things at once: lower the real growth rate, make it more difficult to repay loans, and increase the unemployment rate. All of these issues make it more difficult for governments to function, because governments play a back up role. If workers are laid off from work, governments are expected to compensate laid-off workers at the same time they are collecting less in taxes and bailing out distressed banks. This type of systemic risk leads to the possibility of multiple government failures.

Promises of future oil growth

We keep reading articles claiming that world oil production will grow by some large amount by some future date. One of the latest of these is by Harvard Kennedy School researcher (and former oil company executive) Leonardo Maugeri, called Oil: The Next Revolution. According to the report, “Oil production capacity is surging in the United States and several other countries at such a fast pace that global oil output capacity is likely to grow by nearly 20 percent by 2020, which could prompt a plunge or even a collapse in oil prices.”

Even if the forecast were true (which I am doubtful), the problem is that this is simply too late. We have been having oil-supply problems for some time -- since the 1970s. The rate of oil supply growth keeps ratcheting downward, and the world keeps trying to adapt, with recessions to show for its efforts. Some believe 10 of the 11 most recent recessions were associated with oil price spikes.

We don’t have time to wait until 2020 to see whether the supposed additional capacity (and production) will actually materialize. We have a problem right now. The downturn in oil prices and the reduction in demand in the U.S. and parts of Europe is looking more and more like it may give rise to yet another recession. Based on our experience in 2008-2009, and our difficulties since then, this recession may be severe.

Gail Tverberg is an actuary who since 2007 has devoted herself full-time to issues related to oil shortages, and other shortages, and their impact on the economy. She discusses her findings on her blog, Our Finite World.

This article appeared in The Oil Drum, an online site featuring news and opinion about the petroleum industry, and is republished here with permission. The views expressed here are the writers' own and are not necessarily endorsed by Alaska Dispatch. Alaska Dispatch welcomes a broad range of viewpoints. To submit a piece for consideration, e-mail commentary(at)alaskadispatch.com