Oil Market Wobbles

by: Lipper Alpha Insight


The price of Brent Crude has risen by a little over $5 per barrel since tensions in Iraq began to escalate earlier this month.

Positive shocks to oil demand have accounted for most of the increase in the price of oil since the turn of the century.

The consequences of an increase in the price of oil that has been caused by a reduction in supply are much more pernicious. Iraq has an important role to play.

It is scheduled to supply 60% of the entire projected increase in OPEC output between now and the end of the decade.

Were there to be a one-off reduction in oil supply, we find that after one year oil prices might be $20 per barrel higher than otherwise.

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Writing in 2005, US economist James Hamilton found that nine out of ten post-WWII US recessions had been preceded by a spike up in oil prices. It would be a fairly trivial exercise to update his analysis and find that ten out of eleven post-WWII US recessions have now been preceded by a spike up in oil prices. The relationship between a significant increase in the price of oil, expressed in real terms, and global economic activity is readily apparent in our chart.

Global economic recessions are rare events. If we define a global recession as a fall in global GDP per capita then, using World Bank data, there have been just four since 1960. Of these, three were preceded by a significant increase in the price of oil, measured in constant price US dollars.

The consequences for global economic activity of a change in the price of oil will depend on its cause. If the price of oil is driven higher by an increase in the demand for oil, then one might imagine that the global economy will continue to expand, and perhaps at a rapid pace. However, that does not rule out the possibility of recessions in individual economies, particularly if the increase in the demand for oil is concentrated in a particular country, or in a particular region. Conversely, an increase in the price of oil that is driven by a reduction in oil supply will unambiguously lower productive potential around the world - oil, and energy more broadly are important factors of production - and perhaps by enough to cause the global economy to contract.

According to our models, positive shocks to oil demand can account for almost the entire increase in the real price of oil since the beginning of this century. That is almost certainly a consequence of China's entry onto the world stage. Since 2000, China has roughly doubled its share of world energy usage, and is now the world's largest consumer of energy products.

Moreover, we find that, were there to be a one-off reduction in oil supply equivalent to the loss of around 3.5 million barrels per day then, after one year, oil prices would be around $20 per barrel higher than otherwise. However, this is probably an underestimate of the immediate impact of severe disruption to Iraqi oil supply. In the short term, before other suppliers are able to adjust their output, and before consumers are able to adjust their oil usage, the price is likely to rise by more. In addition, with Iraq expected to increase production materially over the next five years, the consequences of disruption to Iraqi supply are likely to be greater than analysis of current production figures might suggest.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: Alpha Now at Thomson Reuters is a team of expert analysts that are constantly looking at the financial landscape in order to keep you up to date on the latest movements. This article was written by Konstantinos Venetis, independent commentator and analyst. We did not receive compensation for this article, and we have no business relationship with any company whose stock is mentioned in this article.