Sunday, July 19, 2009

The 4% Rule: Oil above US$80 Equals Recession

(WTI Crude at the time of writing is US$64/barrel)
Oil above US$80 per barrel puts the world into an economic death zone.  As was evidenced in 2008, brief spikes above US$80 per barrel are possible but not for more than 6 months.  Historically, the longer oil prices stayed above the economic death zone level the more severe the following recession.

Oil consumption grows predictably when oil spending is below 4% of GDP. For developing nations, oil demand grows as a function of income (measured by GDP) and population. For developed nations oil per capita consumption tends to be relatively stable and oil demand grows with population.

An observation made in Oil 101 (pages 15-16) is that when spending on crude oil has risen above 4% of GDP, global oil demand has fallen. Such global oil demand destruction occurred in 1973-1974, the early 1980s, the early 1990s and in 2008.

(source: page 17, Fig. 1-10, Morgan Downey, 2009, Oil 101)

(source: page 17, Fig. 1-10, Morgan Downey, 2009, Oil 101)

The crude oil price equating to spending 4% of GDP is shown on the following chart along with historical realized prices. As you can see, in 2009 the oil price which equates to 4% of GDP is US$80 per barrel. Anything above US$80 per barrel may reduce global oil demand and prolong the current recession.
Looking to the future, what if supply declines? How much could oil prices increase? If we hold income (GDP) constant and oil consumption efficiency constant (roughly 4.6 barrels per person globally at the moment) then we get the following chart:

The bottom of the recession zone is the oil price equivalent to 4% of GDP and the top of the recession zone is the price equivalent to 8% of GDP (top of demand destroying price spikes historically). 

[Note that if the purchasing power of the US dollar declines in general against all hard assets and not just oil, then, all other things being equal, oil prices equating to 4% of GDP may increase above the levels shown.]
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