Oil price shock

After Hurricanes Katrina and Rita have ravaged the US coast of the Gulf of Mexico, does the fast-rising oil price presage a worldwide economic recession? The track record of oil shocks is indeed close to perfect. In the case of the US, each of the previous three oil shocks was followed by recession.

After Hurricanes Katrina and Rita have ravaged the US coast of the Gulf of Mexico, does the fast-rising oil price presage a worldwide economic recession?

Prior to these current episodes, 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, the subsequent oil embargo imposed on the West by the Organisation of Petroleum Exporting Countries (OPEC) 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 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, or a doubling from prices prevailing before the outbreak of hostilities.

And now it’s the US-Iraqi war. The track record of oil shocks is close to perfect. In the case of the US, each of the previous three oil shocks was followed by recession. The first shock led to the deep recession of 1973-75. The second was followed by a brief recession in 1980, eventually followed by 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, real GDP growth had slowed to a 2.2% average annual rate. In the first half of 1979, average annualised 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.

Why would a sharp rise in oil prices cause an economic recession? It’s because oil remains so important to the profitable running of capitalism worldwide. Sure, there are other forms of energy: natural gas, coal, water, nuclear power, that can fuel industry. But oil and its refined product, gasoline, are still just about the only form of fuel that can power transportation of goods (trucks, planes) and the movement of labour (cars, buses and planes).

The rail industry was once an alternative. But the combination of quicker journey times for trans-continental trips in North America, Europe and Asia, getting across oceans quickly and most important, the growing demand for private (as opposed to public) transport in cars, removed this option.

Capitalism could make much more money from selling cars than it could from providing public transportation through rail or buses. Now capitalism communications and movement depend on oil as by far the most important part of energy.

Rising oil prices not only drive up costs for the economy, they also cut back on the purchasing power of working people and their families. People have to buy petrol to fuel their cars. If petrol prices rise, people cut back on buying other things. So oil prices hit consumption. Less demand for good and services that capitalists sell means less sales revenue. Capitalist profits get hit two ways: from higher costs and less sales.

This effect is particularly heavy for the world’s largest capitalist economy, the US. This is the ultimate gas guzzler economy: Thanks to the lack of public transport and tax incentives to buy cars, there are now more huge gasoline-using sports utility vehicles (SUVs) sold each year than ordinary cars.

In the US, you are really poor if you don’t have a car. The flooding after Hurricane Katrina showed tragically why, when the poor (and mainly black) of New Orleans could not escape Katrina as they had no cars and could not afford transport. The authorities left them to their fate.

An economic recession is very likely then if oil prices stay high. And that looks very likely. Much of the upside seen in crude oil prices has come from increased global demand. The main contributors have been China and the US.

Chinese car sales are booming. In the last year, more than 2.5m were sold. China is a whisker away from eclipsing Japan as the second-largest car market. On current trends, more cars could be sold in China than in the US within the next 15-20 years. That means an awful lot of future demand for crude oil.

And the Chinese regime does nothing about energy conservation or environmental controls. 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.

Oil prices are going to stay high not just because of strong demand, but also because world production is reaching capacity. OPEC is already pumping oil at record rates. The only OPEC producer that claims to have more capacity is Saudi Arabia. It is currently pumping near 10.0mbd. Back in the 1980s, Saudi output briefly peaked at 10.5mbd. So that suggests there is virtually no Saudi spare capacity left.

The big debate among the oil experts is whether there is going to be much oil left in the next five or ten years. Some argue that the world is voraciously draining away the more than a trillion barrels of proven reserves that are still in the ground. Others argue that new technologies will make it possible for oil companies to find new sources of oil and extract new oil from old sources.

There are three reasons for this lack of consensus. First, because oil is buried underground, it is hard to measure: how much oil remains is largely guesswork. Second, the world of oil is shrouded in secrecy. Saudi Arabia won't even allow its reserve and production data to be audited. For the past 17 years the Saudis have claimed 263bn barrels of reserves, yet in that time, they have extracted 55bn barrels of production. So, unless they have somehow replaced that output with new unknown reserves, their figures must have declined.

Moreover, doubts are emerging that Saudi Arabia is even capable of maintaining current production, let alone supplying more of the world’s future oil requirements. Saudi Arabia has been highly reliant on the super giant Ghawar oil field for the best part of 50 years. However, Ghawar is an aging oil field and there have been no new significant discoveries in the Kingdom over the past 35 years.

That’s not to say the Saudis haven’t tried. Saudi Aramco, the state oil company, has invested billions of dollars and utilised the best technology money can buy, but the results have been mediocre, to say the least. Should Ghawar experience significant production declines, Saudi oil output will have peaked.

Sure, Saudi reserves are still huge, so it will take many years before they are exhausted, but the cost of extracting them will go on rising. That will keep the oi price up.

Crude oil supply may not yet be quite at a maximum, but supplies of refined gasoline are. Even before Hurricane Katrina, US gasoline production capacity was running at peaks.

Over the next few months, the damaged Gulf of Mexico refineries will reopen and perhaps gasoline prices will recede a little, but petroleum demand has been running ahead of refining capacity for years. That’s unlikely to be rectified in the immediate future.

No new refinery has been constructed since 1976, so the US has to import 10% of its gasoline needs. The table below shows that gasoline refinery capacity (in millions of barrels per day, MbD) has never been as stretched in 30 years as it is now.

Refinery capacity (Mbd)           Mbd Oil demand (Mbd)

1978    78                                            63

1979    80                                            65

1980    81                                            62

1981    82                                            60

1982    79                                            58

1983    76                                            58

1984    74                                            59

1985    73                                            59

1986    73                                            60

1987    74                                            61

1988    73                                            63

1989    74                                            65

1990    76                                            65

1991    76                                            65

1992    74                                            66

1993    75                                            66

1994    76                                            67

1995    77                                            68

1996    78                                            70

1997    80                                            72

1998    81                                            73

1999    81                                            74

2000    82                                            75

2001    83                                            75

2002    83                                            77

2003    84                                            78

2004    85                                            81

2005    85                                            83

A further problem is the lack of spare capacity in the right type of crude oil. Saudi Arabia may still claim to have spare capacity. However, the bulk of that capacity is in heavy sour crude oil, which is not suitable for refining into gasoline. The US has only 15 days of demand in gasoline inventories, half of what it had just over 20 years ago.

Embarrassingly, in the Katrina crisis, the US had to consider offers from Venezuela and Europe for gasoline. Having 700m barrels of crude oil in the US Strategic Petroleum Reserve was no help with the Gulf coast refineries down.

Crude oil prices have been rising for the past five years. Up to now, US consumers have shrugged off this extra cost of energy. However, every time the real price of gasoline has risen in excess of 20%, as in 1974 and 1979-80, it induced a sharp consumer spending slowdown that led to economic recession. Now, even if US pump prices fall back under $3 a gallon for the rest of the year, the real gasoline price will still be up more than 20%. .

In the last three oil price shocks that led to economic recession, the oil price in real terms (after taking into account general inflation) reached at least $40/b. The current oil price of $65-70/b is equivalent to a real price of about $45-50/b (see table below). So if oil and gasoline prices stay where they are over the next six months, the US and the world economy could be staring recession in the face.

Excess capacity (millions of barrels; left scale)

Real oil price (2003 $US; right scale)

1970    4.1       9.99

1971    4.4       11.68

1972    4.4       12.31

1973    2.8       12.98

1974    4.1       41.85

1975    7.6       36.21

1976    4.3       38.21

1977    4.8       38.96

1978    6.5       36.51

1979    4          74.06

1980    5.7       79.21

1981    7.1       69.01

1982    9.3       61.02

1983    9.8       53.77

1984    9.2       50.52

1985    10.2     46.79

1986    8.3       23.79

1987    8          29.46

1988    6.1       22.97

1989    5.4       26.58

1990    3.2       32.36

1991    1.2       26.16

1992    1.8       24.96

1993    2.9       21.37

1994    3.1       19.79

1995    3.1       20.77

1996    2.9       23.89

1997    3.1       22.08

1998    3.2       14.76

1999    5          19.86

2000    3.1       30.16

2001    4.1       25.28

2002    5.6       25.52

2003    1.8       28.89

2004    1          36.48

2005    0.5       48.5