Did Spiking Oil Prices Put Us On A Path To Recession?

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Includes: OIL, SPY, USO
by: PLM Investments

Summary

The U.S. economy has been struggling over the last year.

Spiking oil prices are strongly correlated with recessionary conditions.

Recently high oil prices have contributed to the current economic downturn and may indicate an increased possibility of recession.

Spiking oil prices around $100/barrel could have put this country on an inevitable course toward an economic downturn.

In an earlier article, I argued that we could see oil (NYSEARCA:USO,OIL) at $20-40/barrel for along time. If anyone remembers the late 1980's, the 1990's and even the early 2000s, they'd tell you $100 oil talk was crazy back then. (Even though the inflation-adjusted oil price breached this mark in the 1970's.) $20-40 is not the new normal, it's really the old normal.

The recent roller-coaster ride of oil prices up above $100 and back down under $30 could have repercussions. It's well-known that oil-price shocks often precede economic downturns, including recessions. The oil price variations over the last several years correspond to such a shock, so we may very well expect a downturn now. This would obviously impact the stock markets (NYSEARCA:SPY) as earnings would broadly suffer.

Are we already in a downturn? Economic projections indicate GDP growth rate weakness well into 2016. While some measures indicate we are already in a strong downturn other measures are more neutral.

So, what should we be expecting in the near future owing to the recent oil-price variations?

We've been through a relatively recent oil price shock and now that we've had a price correction, the structure of the movement is readily apparent. Take a look at the oil price chart below, which shows recessions in gray. This is an inflation-adjusted semi-log plot to highlight the variations. Its quite clear that oil price spikes are associated with recessions. They seem to precede or coincide with nearly every recession since the 1950s.

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A 2014 study "The Role of Oil Price Shocks in Causing U.S. Recessions," for the Federal Reserve took a closer look at the relationship, comparing data using linear and nonlinear models. They noted their reason for the study as "Although oil price shocks have long been viewed as one of the leading candidates for explaining U.S. recessions, surprisingly little is known about the extent to which oil price shocks explain recessions."

Their study looked at the impacts of oil price shocks defined as three consecutive years of oil price increases. These are denoted by red stars in the chart below. Note that red stars precede all of the recessions. And the chart ends with a red star at the beginning of 2012.

Click to enlarge

Through their models, however, they concluded that the cumulative causative effect of an oil price shock is typically less than 1% of GDP growth reduction.

Another report based on statistical data analyses indicated 0.5% decrease in GDP at three years for every 25% increase in oil price. This would result in 0.5%-1% total negative impact during the current timeframe.

The results from these two studies agree: we shouldn't be too concerned about the spikes per se as they have a small effect. However, the ongoing GDP growth rate seems to have been lowered since the Great Recession, so the negative economic impact of even a small oil price spike could be more significant than at previous earlier high-growth times.

There must be other more important factors that have historically coincided with some oil price spikes actually causing the prior recessions. These contributing factors could include credit supply conditions, monetary policy, and consumer confidence. The causative effects of these factors haven't been determined by economists yet, but they too may be more significant under current conditions.

Regardless of the causal effects, the oil price spikes can be indicative of future economic downturns without being the primary cause. They provide a measure that is an obviously recognizable potential leading recession indicator.

Also, keep in mind that extended low oil prices can aid an economic expansion, so the large downward shift in oil prices could mute current recessionary pressures.

The bottom line is that recessions often, but not always, follow price shocks. Oil price spikes tend to be only weak contributors to economic downturns. The recent 3-yr oil price shock that ended around 2012 could be interpreted as a contributor to the current slowdown but should not be interpreted as causing an impending recession.

This is useful input for investment decisions as it cautions us to now be watchful of evolving economic conditions and it helps us assess the current risk environment.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.