Global: Oil-Shock Assessment
Stephen Roach (New York)
Morgan Stanley
Aug 19, 2004
With oil prices now in the high $40s (WTI basis), there is good reason to treat this development as yet another in a long string of energy shocks. The impact of such disruptions depends very much on context -- namely, the vulnerability, or lack thereof, in the underlying economy. When a weak economy is hit by any type of a shock, recession normally results. Conversely, a strong economy is better insulated to withstand such a blow. Most of the oil shocks of the past fall into the former category -- hitting economies when they are vulnerable. Unfortunately, the Oil Shock of 2004 fits that script to a tee.
Is this truly an oil shock? History gives us some guidance in making that determination. Prior to the current episode, there have been three major oil shocks in the last 30 years -- all stemming from geopolitical disturbances in the Middle East. Following the Arab-Israeli Yom Kippur War of October 1973 and the subsequent oil embargo imposed on the West, OPEC I led to a quadrupling of oil prices. In the aftermath of the Iranian Revolution in 1979, the Iranian-US hostage crisis, and the Iraq-Iran War of 1980, OPEC II led to a near tripling of oil prices. Then there was the Iraqi invasion of Kuwait in 1990 that triggered a brief spike in oil prices to $40 that represented a doubling from quotes prevailing before this outbreak of hostilities. And now it’s the US-Iraqi war.
As new price shocks occur from ever higher levels of the nominal oil price, the percentage increase will, by definition, be smaller. That’s very much the case today. Over a year ago, after the end of the first phase of the Iraq War, WTI-based oil quotes hit their low point of about $25 per barrel. The subsequent run-up to $47 represents nearly a 90% increase from pre-war levels. Yet that’s probably a misleading comparison. It makes more sense, in my view, to compare recent price fluctuations to a longer-term average, which provides a closer approximation of equilibrium price expectations and oil consumption patterns. Only on that basis, can judgment accurately be rendered as to whether a price shock has occurred.
At the current level of around $47, oil prices are 62% above the $29 average that has prevailed since early 2000. That takes the “real” oil price (i.e., WTI quotes deflated by the headline CPI) back to levels last seen in the late 1980s; in fact, other than the brief spike in late 1990, the current increase represents the sharpest run-up in the real oil price since the late 1970s. I have maintained for some time that the “true” shock probably comes with $50 oil (see my May 10 dispatch, “Global Wildcards”). That would represent in excess of a 70% surge above the post-2000 average -- enough of a spike, in my view, to put it in the ballpark with full-blown oil shocks of the past. At $47, world oil markets are now too close for comfort to that critical price point. Duration obviously matters -- the price has to stick at these levels for 3-6 months to qualify as a legitimate shock. But the first condition has now been satisfied: The oil price is firmly in the danger zone.
Do oil shocks hurt? The track record of oil shocks is close to perfect. In the case of the United States, each of the previous three oil shocks was followed by recession. OPEC I led to the deep recession of 1973-75. OPEC II was followed by a brief recession in 1980 and eventually set the stage for a severe recession in 1981-82. And the Gulf War Shock was followed by a mild recession in 1990-91. These cyclical contractions all had one thing in common: The US economy was already vulnerable when it was hit by a shock. In the final three quarters of 1973, just before OPEC I, real GDP growth had slowed to a 2.2% average annual rate. In the first half of 1979, just before OPEC II, average annualized growth slowed to just a 0.6% pace. And in the three quarters prior to Iraq’s invasion of Kuwait, real GDP growth slowed to a 2.2% clip. In all cases the US economy was at or near its “stall speed” when the oil shock occurred.
History tells us that the stall speed and a shock are a lethal combination. For that reason, alone, conventional rules of thumb -- a $10 increase in oil prices knocks about 0.4% off GDP growth -- typically don’t work when an economy is near its tipping point. The closer to the stall speed, the thinner the cushion that is available to withstand the unexpected pressures of an exogenous disruption. Recessions are the rule, not the exception, in that context. That’s very much the risk today. The current recovery in the US economy has been the most anemic on record. While there was a policy-induced spurt of 5% real GDP growth from 2Q03 to 1Q04, gains in the other seven quarters of this upturn have averaged only 2.2%. Moreover, the renewed slowing to a 3% pace in 2Q04 masks a 1% gain in real personal consumption expenditures -- matching the weakest quarterly performance since early 1995. In my view, America’s saving-short, overly-indebted, job- and income-constrained consumer looks as vulnerable as ever. Add to that the ever-mounting perils of outsize twin deficits and there is good reason to believe that an inherently vulnerable US economy could be hit hard by another oil shock.
Supply or demand? Of course, not all oil shocks are alike. History also tells us that a supply disruption hurts far more than an increase in the oil price stemming from an increase in demand. Yet with the global economy now starting to soften, the demand explanation seems less credible. Decelerating growth in the US, Japan, and China, along with persistently sluggish growth in Europe hardly points to a build-up of pressures on the demand side of the equation. At work, in my view, is a classic “geopolitical angst premium” -- dominated by uncertainties in Iraq, Russia, and Venezuela, along with concerns about terrorism and the Israeli-Palestinian struggle. Add to that a tight supply-demand balance -- especially for refined petroleum products -- and this oil price run-up has all the characteristics of the disruptive shocks of the past.
That same argument, of course, paints an equally compelling picture of the potential for a sharp decline in oil prices. Relief on the geopolitical-tension front could certainly change supply expectations and quickly take oil prices a good deal lower. How much lower is anyone’s guess. The case for reduced geopolitical angst is also anyone’s guess. But right now, all we know is that the oil price is high enough to make a real difference to a vulnerable US and global economy. If today’s surge miraculously turns into nothing more than a momentary spike, then the downside to the global economy will be both contained and brief. It sure doesn’t feel that way at the moment, but stranger things have happened. Whatever the outcome, the macro conclusions are relatively straight-forward: Growth optimists need oil prices back in the $30 range. Growth pessimists draw support when oil is the $40 range. As always, only time will tell.
What about energy conservation? In my experience, every time oil shocks occur, there is an inclination to dismiss the impact on the basis of the reduced energy content of industrial world GDP. Obviously, that was not the case during the first oil shock of the early 1970s, but this has been a very popular view in every shock since. On the surface, the numbers are compelling: For the United States -- the world’s largest consumer of energy -- Dick Berner calculates that energy consumption per unit of GDP has fallen by 46% over the past three decades. Similar results are evident in other major industrial economies -- especially Germany, the UK, Canada, Italy, and Japan. With conservation leading to sharply improved energy efficiency, there seems to be good reason to temper any concerns over oil shocks. Yet that view hasn’t worked out very well over time. Since OPEC I, each successive energy shock has still managed to spark recessions in the industrial world -- despite meaningful progress on the conservation front. In large part, that’s because of the reasons noted above -- namely, that it doesn’t take much to tip an already vulnerable economy into recession.
There’s one other key element of the conservation story. For every developed country that is reducing the energy content of its GDP, there is rapid growth in the energy-guzzling Chinas and Indias of the developing world. According to the International Energy Agency, in 2002, China’s oil intensity -- primary oil consumption per unit of GDP -- was 2.3 times that of the average OECD developed country; India is even worse -- fully 2.9 times the OECD average. Little wonder that China, which makes up slightly less than 4% of world GDP, accounted for fully 7% of the world’s crude oil consumption in 2003. In that same vein, the emerging China slowdown would seem to provide some relief to world oil demand. However, given the nation’s widespread energy shortages, in conjunction with its recent indications to start building a strategic petroleum reserve, any cyclical curtailment in Chinese oil demand might be surprisingly limited. It may well be that globalization is an inherently energy-intensive endeavor -- suggesting that world oil markets might enjoy little relief from ongoing conservation efforts in the developed world.
All in all, it now appears that the world is being subjected to its fourth oil shock in 30 years. It’s quite possible, of course, that the geopolitical complications could unwind and oil prices retrace a significant portion of the recent run-up. But that’s pure guesswork at this point. The best we can do is take a snapshot of where we are and attempt to assess the macro implications of the current pricing structure. Under the presumption that such prices stick near current levels, the outlook is worrisome, to say the least. Just as the previous three oil price disturbances led to recession, there is good reason to fear a similar outcome in 2005. For an unbalanced world that has run out of policy stimulus, there can be no mistaking the mounting perils of another energy shock.
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