During the last century, cheaper oil prices gave a boost to global economic growth. However, during the last decade, prices for oil surged, and that change will permanently cap the growth potential of the world’s economies.
The potential economic growth of countries consuming the large amounts of oil is taking the biggest hits. That is crucial news for the U.S., which consumes almost a fifth of the oil used in the world every day. When oil price was $20 a barrel, the U.S. was the engine of global economic growth, the federal government was running budget surpluses, and the jobless rate was at a 40-year low. The current situation is quite different – growth is in stagnation, the deficit is more than $1 trillion and almost 13 million Americans are jobless.
The U.S. isn’t the only country experiencing such problems. From Europe to Japan, governments are trying to restore economic growth. But the remedies being used are doing more harm so far than good, since they are based on the belief that economic growth can return to its former glory. Central bankers and policy makers have been unable to fully recognize the negative impact of $100-a-barrel oil.
Running huge budget deficits and keeping borrowing costs at record lows are only some of the current problems. These policies cannot be long-term substitutes for cheap oil. The reason for that is the fact that an economy can’t grow if it can no longer afford to burn the fuel on which it runs. The end of growth means governments will need to change fiscal and monetary policies to account for slower potential growth rates.
Oil is the source of more than a third of the energy we use on the planet every day. There is a differentiation between oil consumption and gross-domestic- product growth. The oil we burn boosts the growth of the global economy. On average over the last four decades, a 1 percent jump in world oil consumption has led to a 2 percent growth in global GDP. That means if GDP rose 4 percent a year, which was not uncommon before the 2008 recession, oil consumption was hiking by 2 percent a year.
At $20 a barrel, growing annual oil consumption by 2 percent appears to be reasonable enough. At $100 a barrel, it becomes easier to see how a 2 percent growth in fuel consumption is enough to make an economy crash.
On the bright side, the opposite case scenario is also true. If our economies stop growing, we will need less oil. For instance, after the big recession in 2008, global oil demand actually dropped for the first time since 1983. That’s why the best cure for high oil prices is high oil prices. When prices hike to a level that triggers an economic collapse, lower prices inevitably follow.
Each time oil prices have surged over the last four decades, the global economy has entered a crisis.
Think of the first oil shock, after the Yom Kippur War in 1973, when the Organization of Petroleum Exporting Countries’ Arab members turned off the taps on roughly 8 percent of the world’s oil supply by cutting shipments to the U.S. and other Israeli allies. Crude prices hiked, and by 1974, real GDP in the U.S. had narrowed by 2.5 percent.
The second OPEC oil shock took place during Iran’s revolution and the war with Iraq that followed. Problem with Iranian production during the revolution caused crude prices to surge, pushing the North American economy into a crisis for the first half of 1980. A few months later, Iran’s war with Iraq shut off 6 percent of world oil production and sent North America into a serious crisis that began in the spring of 1981.
A decade later, when Saddam Hussein attacked Kuwait, oil prices surged to $40 a barrel, an unheard-of level at the time. The first Gulf War shook almost 10 percent of the world’s oil supply and sent major oil-consuming countries into a crisis in the fall of 1990.
In 2008, when the world fell into the deepest recession since the 1930s oil prices marched steadily higher before reaching a peak of $147 a barrel in the summer of 2008. Unlike past oil price fluctuations, this time there wasn’t even a supply disruption to blame.
There are many ways an oil fluctuation can negatively impact an economy. When prices increase, most of us have no choice, but to pay more for everything. This means that we have less cash to spend on food, shelter, furniture, clothes, travel and pretty much anything else. Expensive oil, along with the refusal of most Americans to drive less, leaves a lot less money for the rest of the economy.
Unfortunately, when oil prices rise, they are followed by inflation. And when inflation rises, central banks raise interest rates to keep prices in check. The Consumer Price Index shows that from 2004 to 2006, U.S. energy inflation ran at 35 percent. As a result, overall inflation hiked from 1 percent to almost 6 percent. What happened next was a fivefold increase in interest rates that ruined the U.S. housing market. Higher rates made the speculative housing bubble blow. Consequently, the global economy collapsed.
Unfortunately, we see this pattern of oil-driven inflation once again. And world food prices are being affected. The food-price index indicated by the United Nations Food and Agriculture Organization showed that the cost of food increased by almost 40 percent from 2009 to the beginning of 2012. Moreover, the FAO’s food-price index has increased by 150 percent since 2002.
Rising oil and food prices mean that inflation will be here sooner than anyone would like to think.
Rising inflation rates in China and India are an indicator that those economies are growing at an unsustainable pace. China has made GDP growth of more than 8 percent a priority. However, it needs to reconsider its ways and to recognize the negative effects of high oil prices. Growth might not go into stagnation entirely, but clocking double-digit gains is no longer an option, at least without causing a dramatic increase in inflation. If China and India, the new locomotives of global economic growth, are forced to adopt anti-inflationary monetary policies, resource-based economies such as Canada, Australia and Brazil will feel the ripple-effect immediately.
Triple-digit oil prices will end the big economic hopes of India and China, whose aim is to achieve the same sort of sustained growth that North America and Europe enjoyed in the postwar era. There is a big problem that make such ambitions impossible – oil isn’t flowing from the same places it did before. Moreover, it’s not flowing at the same cost.
Conventional oil production hasn’t increased in more than five years. And that’s now, when record crude prices give explorers all the stimulus in the world to drill. The International Energy Agency announced that conventional production has already reached its peak and is set to drop steadily over the next few decades.
That doesn’t mean there won’t be any more oil since new reserves are being found all the time in new places. The expected decline in conventional production means that future economic growth will be caused by expensive oil from nonconventional sources such as the tar sands, offshore wells in the deep waters of the world’s oceans and even oil shales, which come with environmental costs that range from carbon-dioxide emissions to potential groundwater contamination.
All in all, even if new supplies are found, what matters to the economy is the cost of getting that supply flowing. It’s not enough for the global energy industry simply to find new sources of oil. Triple-digit prices will indeed make it profitable to tap ever-more-expensive sources of oil. However, the prices needed to acquire this crude will throw our economies right back into a crisis.
The goal of the energy industry is not simply to find oil, but also to find stuff we can afford to burn. Each new barrel we acquire is costing us more than the last. Today, the world consumes about 90 million barrels of oil a day and if our economies are no longer growing, maybe we won’t need any more than that. Moreover, we might even need less – in this way the oil in the sands or under the Arctic Ocean will stay where nature put it.
