The Effect Of The Coming Recession On The Oil Price
The U.S. economy is in boom mode, approaching what Mel Brooks’ called “Ludicrous Speed,” and at some point there must be a slowdown if not an outright recession. A standing economic joke was that once economists agree that we’ve conquered the business cycle, expect a recession. An indicator I like to use is “more money than brains,” referring to egregiously wasteful spending as a sign of an overheated economy. In the past, the spread of “oxygen bars” where customers paid to inhale a lungful of air from exotic places like the Antarctic or Mount Everest, suggested that we had reached the point of conspicuously ridiculous consumption, and something was likely to give. Now, people are selling orbs of ‘raw water,’ which is clearly a case of ridiculously conspicuous consumption.
Combine that with the fact that the U.S. stock market is at historic highs, with price to earnings ratios well above historic norms, and unemployment is extremely low, finally generating (gasp!) wage inflation. It would be nice to think that with American, European and Asian economies all surging they would mutually reinforce each other and bring a new era of super-prosperity to the world without inflation or rising interest rates.
It would be nice, but seems unlikely. More probably, there will be a sharp correction in the stock market, higher interest rates, rising (but maybe not high) unemployment and something between slower growth and a recession, hopefully nowhere near as severe as 2008. Forecasting the macroeconomy is not my area of expertise, so it isn’t my intention to suggest I am confidently predicting a slowdown. Rather, hypothesizing that such may occur and trying to see what the impact on oil prices would be.
Unlike industrial commodities such as steel and copper, demand for oil is much less responsive to recession, especially motor gasoline consumption. As the figures below show, jet fuel and distillate (diesel mainly) dropped much more sharply during the 2008/9 recession than gasoline did. Overall, U.S. oil consumption dropped by about 2 mb/d, over two years. (Figure below) Recessions are rarely avalanches, although faster than erosion. This is confirmed by OECD consumption during the same period, where it dropped by nearly 5 mb/d, but again, this took over 2 years to occur. (Next figure)
To what degree would a new recession affect oil prices? It depends. Mostly on how broad and deep the recession is. Potentially, a U.S. slowdown would cause a global recession and oil demand would drop by over 0.5 mbd a quarter, about half of what was seen in the 2008 experience (extrapolating OECD demand to the world). This means adding 45 million barrels a quarter to inventories, which is not exactly abnormal (see next figure). Monthly changes of 20-30 million barrels just for OECD nations, which account for less than 50% of world consumption (and an unknown but presumably similar portion of inventories)
The rate of change is also important. Demand drops relatively slowly, giving OPEC plenty of time to respond. And offsetting transient market changes is precisely the role of cartels (something frequently used in European and Asian countries). Of course, there is always likely to be some uncertainty about real demand and inventory trends, given impartial and delayed data, and it is possible that OECD inventories will increase again, perhaps even by 100 million barrels or more, but as of now, at least, traders appear much more confident that producers will cope with the weakness, rather than allow a new price collapse. That said, weaker prices (at least relative to current levels) would be pretty likely in such a scenario.