There are many ways that oil shocks affect the economy, and none of them is good. As the prices of gasoline, diesel and home heating fuel rise, consumers’ energy bills eat up a growing share of their after-tax income, forcing cutbacks in more discretionary areas of spending. The next thing you know, people are going out to restaurants a lot less, taking fewer vacations and buying fewer clothes.

Soaring oil prices also transfer billions of dollars of income from oil-consuming economies to oil-producing economies. Nearly one trillion dollars migrated from OECD economies to OPEC ones in the record run-up of oil prices preceding the last recession. Since savings rates in countries like Saudi Arabia, UAE and Kuwait are typically ten times what they are in major oil-consuming economies like the United States or Western Europe, the shift in purchasing power resulted in weaker global demand.

But by far the greatest impact that oil price shocks have on the global economy is the one they make on inflation and, hence, interest rates. This linkage is the means by which they have typically delivered a mortal blow to economic growth. Oil shocks have always given rise to growth-ending increases in interest rates as central banks are forced to respond to the inflationary fallout they leave behind.

The last recession was no exception. As oil prices soared from $35 per barrel in early 2004 to almost $150 per barrel in the summer of 2008, consumer price inflation in the US tripled to a rate of almost six per cent. It didn’t take long before interest rates caught up to inflation and, in the process, blew up the massively over-leveraged subprime mortgage market and the economy with it.

But lest we’d forgotten, it was the massive rise in energy inflation, and an associated rise in food prices (more on that in future posts), that catapulted the Federal Reserve Board’s federal funds rate from a nurturing one per cent setting in early 2004 to a level over five times that only a couple of years later. The rate of energy inflation rose from less than one per cent to as high as 35 per cent.

Oil prices caused the last recession, and oil prices will cause the next one as well. Energy inflation is already on the march. In fact, this time around oil prices are rising much earlier and much more rapidly than they did last cycle. Inflation is already running at nearly a five per cent rate in China; as oil prices go on to set new record highs, it’s only a matter of time of before we see those inflation rates in North America and in the rest of the OECD.

And when we do, get ready for another oil-induced global recession.

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  • http://www.facebook.com/people/Michael-Cole/100001890616958 Michael Cole

    I recall reading somewhere that the US dollar was yellow backed, then gray backed, now it's oil backed (or I suppose black backed) currency. The reason the US invaded Iraq was to shore up it's own currency according to the article I read. Now I read, again, how inflation is induced by high oil prices and I have to wonder, what happens as oil becomes rare, what will the Fed do when hiking rates does not improve the purchasing power of the dollar?

  • Stone14z

    Of course, regardless the highs oil makes when the next global recession hits, oil will drop significantly from those highs as the recession unfolds, only to make new highs once again as the world starts to recover from that recession. And so the cycle will continue repeating…

  • JB

    The UK “growth” during the last quarter of 2010 was already down to minus 0.5%…

    JB

  • nom_de_guerre

    Until? Just wondering how far can people delay acknowledging simple things that can be solved pragmatically.

    The Parliamentary group on peak oil proposes fuel rationing, which sounds sort of like a flacid incentive for the conversion of transport infrastructure based on oil.

    http://teqs.net/report/

    My guess is that before enforcing that particular type of political hara kiri the taxes on fuels will be cut gradually, even in the middle of the current austerity-driven recession (that is just warming up), to please and hide the inevitable from most voters.

  • Jasonlong33

    JLOCalgaryCrude

    Locally in Calgary With this yo-yo effect with oil going to $147 per BBL then down to $40 then back up to $92, we are in a period of total chaos. I can tell you that there are many manufacturing & engineering & service companies who have closed or have layed off thousands in the past year. Now we are looking around and asking who is going to build all of this stuff now that the boom is back on.

  • Jasonlong33

    Jeff,

    Did you see the IEA & BP reports on how much ethanol they have forcasted to 2030. 5 million barrels per day of oil equivalent (That would be 7.2 MM BBL per day at 70% equilavent efficiency). This number is almost unbelievable. People will be starving & rioting all over the world. Does anybody care that governments in Tunisia & Egypt have collasped because of these effects. Wow!!!

  • Terry

    Hi Jason

    I hope they are looking at algae as the source of this, rather than food, otherwise, the planet will be burning with riots everywhere.

  • cleitophon

    Well, there are beginning reports of stagflation in the UK, where the economy contracted in the last quarter of 2010, while inflation hit record highs. Also the US has had proxy measure suggesting a development in that direction.

    It really is time that politicians started addressing the fundamental sustainability of globalization and the modern economies, not only in terms of resources such as oil, copper, rare earths, food an water, but also the shameless printing of money! STOP PRINTING MONEY.

    Secondly politicians should stop selling lies like electrical cars, which are supposed to give people the impression that things will go on like before, but with clean-tech. There is no way electrical cars are a viable solution. Do the numbers: 250.000.000 cars in the US. petrol cars have 20 kg of copper and electrical cars need 90 kg. That 70 kg of copper for every car (17.500.000.000 kg of new copper) and we are currently extracting at 0.6%. It is NEVER going to happen. Now expand that to all the cars in Europe and Asia also or all the worlds 800.000.000 cars. Its a pipe dream.

    It seems very obvious that the politicians are flogging a dead horse and are at their wits end as what to do.

  • Jim Schwartz

    Nothing will get us to alternative energy sources faster than an orderly increase in the price of oil. Order being the operative word here notes the core problem; we don't seem to have a mechanism to discipline us toward a orderly increase of price, and instead, are on a boom-and-bust cycle that greatly diminishes our ability to prepare for our energy future.

  • cleitophon

    History is on the move!

  • Abitibidoug

    I'm curious where you get the figure of 90 Kg of copper per car. Last week I was at the Detroit Auto Show, where some electric and hybrid drive trains were on display and while they do use more copper than conventional petrol cars, it didn't seem like that much more. In any event, unless copper demand falls in emerging market countries like China (not likely) there will be more demand for copper and the price will inevitably go up. Other potential problems with electric cars include where to get all that lithium for the batteries, and how the power grid will handle charging up all those cars. Electric cars are a partial solution to the problem at best.

    As for the politicians, they are at wits end because they believe that the only way to deal with problems is to grow our way out of them. That may have worked in the past, but as resource availability becomes the limiting factor it may not work in the future. Yes, it appears the world of the future is not going to be like the world of the past.

  • cleitophon

    Well I've read is several places. One source was here:

    “”You see more hybrids on the roads these days and that has generated a lot of excitement about these dynamic new products,” Weed says. “The public is definitely interested.”

    That’s good for the copper industry. The average car produced in North America has 50-55 pounds of copper in it. In an electric car, the amount of copper will triple – to 150-180 pounds, Weed says. More than half the copper is in the car’s wiring harness and electrical components.

    There’s significantly more copper used in vehicles today, particularly electric and hybrid electric vehicles, says Pete Savagian, director-hybrid and electric architecture for General Motors Engineering. According to Savagian, the new Chevrolet Volt contains two electric motors and two inverters.

    “The motor is larger in the electric vehicle because it drives the wheels, causing the current to go up by hundreds of amps,” Savagian says. “Cables (made with copper wiring) are larger and heavier in order to carry the current and higher voltage.””

    http://www.copper.org/about/pr…

    The strange thing is this – its not rocket science. We are given numbers and its just a question of basic arithmetic to test whether it can be done in economies of scale or whether there are resources to replace existing technologies on a global level. And the fact is: it cannot be done! Even if the goal was to replace say 5% of the worlds current cars with electric, it would stretch the copper and rare metals resources way beyond anything current markets could handle.

    The truth is this: the populations are given these idiotic projects to pacify them for a while yet, cause there would be a general uproar if politicians started addressing the fundamental sustainability of the current situation.

    I mean – jesus christ – here in denmark they build motorways left right and centre, and have just decided to build an 18 km tunnel to Germany from Zeeland and planning megamarkets so people have to drive 30 km to get their groceries, all the while depletion rates suggest that the first petrol shortages will begin to affect the world in 2012-13.

    “The US Joint Forces Command forecasts that: “by 2012, surplus oil production capacity could entirely disappear, and as early as 2015, the shortfall in output could reach nearly 10mb/d.” [30]
    The UK Industry Task Force on Peak Oil and Energy Security predicts: “as early as 2012/2013 and no later than 2014/2015, oil prices are likely to spike, imperilling economic growth and causing economic dislocation.” [31]
    Lloyds of London says: “an oil crunch is likely in the short to medium term” and “appears likely around 2013.” [32]
    A German military report states: “some probability that peak oil will occur around the year 2010 and that the impact on security is expected to be felt 15 to 30 years later… [there will be] “partial or complete failure of markets… [including] shortages in the supply of vital goods could arise.. A restructuring of oil supplies will not be equally possible in all regions before the onset of peak oil.” [33]
    The IEA writes: “current global trends in energy supply and consumption are patently unsustainable…the era of cheap oil is over.” [34] “

    http://www.parliament.nz/en-NZ…

    It is essential that politicians stop talking about money and start talking about resources!

  • nom_de_guerre

    I'm not saying that high fuel and food prices weren't a factor, or even a catalyst for the public uprising but you to have carefully take into account a bunch of other factors common to these countries: unusually high unemployment affecting especially young men; mild but openly corrupt authoritarian regimes and an educated and economically influential middle class that emerged in the last decade.

    I'm not saying that commodity prices don't exarcebate public unrest or that the indirectly caused economic stagnation or recession doesn't do the same thing but it is always wise to look at the whole picture.

  • Abitibidoug

    There's the saying: there is difficulty in every opportunity, and opportunity in every difficulty. If high energy and resource prices cause inflation and rising interest rates, and cause a double dip recession (quite likely) it will create a good opportunity to buy energy and mining company (especially copper) stocks. Metal recycling companies could also be a good bet. Stay tuned, there are interesting times ahead.

  • Will C.
  • cleitophon

    Its a really long text, could you explain the point you want to make :)

  • cleitophon

    I just cannot believe that this kind of news doesn't get more coverage???? It is absolutely unfathomable!

    http://www.ft.com/cms/s/0/1e31…

    “Saudi Arabia will be burning most of its oil production domestically in less than 20 years if current consumption patterns persist, a senior official has warned.

    In response, the authorities plan to cut reliance on fossil fuel and develop an alternative energy mix, including atomic and solar sources, as rising local demand could dramatically curtail the kingdom’s ability to export oil.

    The world’s largest oil exporter will need 8m barrels a day by 2028, roughly equivalent to its current production, merely to meet domestic energy needs, Hashim Yamani, president of the King Abdullah Atomic and Renewable Energy City, said on the sidelines of a conference on Sunday. The kingdom currently burns a total of 3.2m/b a day, he said.”

  • cleitophon

    Straight out of the Jeff Rubin play book:

    “Container vessels are sailing at the slowest speeds in at least two years to save on fuel costs, driving up freight rates and the shares of shipbuilders. “

    http://www.bloomberg.com/news/…

  • Denny

    Despite rising gasoline prices, Americans cling to their love affair with large vehicles http://www.nytimes.com/2011/02/02/business/02auto.html?ref=business. Is the path to energy independence best taken in a shiny new truck? Looking forward to those Super Bowl ads of massive pick-ups pulling a trailer on a dusty road alongside the Suez Canal.

  • Abitibidoug

    I read today (Feb. 2) in the Globe and Mail business section the sale of trucks has increased more than cars in the last year. The increase is probably due largely to incentives. Are you looking to buy a truck? If so, just wait until the next price shock (petrol is now at $1.14 per litre, give or take a few cents, in Ontario now) really hits proud owners of these new trucks and you will be able to buy a slightly used one at a good discount price. It has happened before, and will probably happen again.

  • Anonymous

    Ta-daaa, here’s the political pressure to create tax cuts for fuel: http://www.guardian.co.uk/money/2011/feb/08/fuel-duty-tax-cuts-green-alliance

    That was faster than I thought.