March 5, 2011

When Oil Doubles, Watch Out Below

David Rosenberg, the (of late) very bearish economist, on the correlation between sharp increases in oil prices and recessions. Is the doubling in the oil price a game-changer, he asks?
Well, there have been only five times in the past 70 years when this has happened within a two-year time frame: January 1974, November 1979, September 1990, June 2000, and August 2005. And now, December 2010.

Each period had its own particular spark. The first three were supply shocks and the last two (before the latest round) reflected burgeoning demand growth, which ultimately acted as a break on the economy.

It is worth noting that the oil price doubled this time around in December, before any turbulence in the Middle East or North Africa, and broadly reflected the physical demand/supply balance globally in crude. There was perhaps some impetus from QE2 as the oil price was around $75/bbl in August and closed the year closer to $90/bbl. Since that time, oil prices have jumped around 10% and that has occurred amidst the supply concerns emanating from the political turmoil overseas. Either way, the longer the oil price stays elevated, the more lasting damage it will inflict on the global economy, primarily the countries that are large net importers of energy.

Of the five instances cited above, all but one involved a recession for the U.S. economy and that was in 2005 during the height of the credit and housing boom, which acted as a huge offset. But oil prices did keep rising and managed to outlast the euphoria in credit and residential real estate, so the recession may have been delayed at the peak of the ‘growth rate’ in the oil price, but it was not derailed as history shows.

Without resorting towards definitions of what constitutes a recession, what has happened 100% of the time in the past is that a year after the month in which the oil price doubles, the economy slows down and does so precipitously. Using year-on-year real GDP growth as the yardstick, the economy slowed an average of 2.3 percentage points; the range was 0.9 to 4.4ppts; and a median of 2ppts. The starting point in Q4 of last year was +2.7% and so you can imagine what a 2-plus percentage point haircut would do to the economic and earnings landscape. Keep in mind that all it took was a moderation to 1.7% growth in the second quarter of last year to induce a near 20% correction in the U.S. stock market and some deeply rooted double-dip fears.

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