High oil prices present recession risk

Brent Dec12.pngOil prices are heading for a second successive year of record annual prices. Last year, Brent averaged $111/bbl and it is averaging similar levels so far in 2012. History suggests this is very bad news for consumers, for companies and for the global economy.

The reason is that consumers in most major economies are now paying record or near-record prices for gasoline and diesel, and for heating or cooling their homes. But their incomes have not risen to match these higher prices. So they have been forced to cut back on other spending. In turn, this is now reducing corporate earnings and risks tipping the world into recession.

The chart explains the issue in its historical context. Since 1970, oil prices have mostly been below 3% as a share of global GDP. The exceptions when it was above this level in 1973/4, 1979/80, 1989/90 and 2007/8 were all followed by recession. The impact is not immediate though, due to the inefficiency of the mechanisms by which higher oil prices are passed through to end-users in the major industry sectors.

Crude oil itself is traded in real-time on electronic exchanges and in physical markets. But buyers cannot then immediately increase their own prices. Typically, prices downstream are set for 6 months or even a year ahead, in line with the needs of consumer industries such as retail and autos.

Thus when oil prices start rising, buyers down the chain have to rush into the market and buy furiously, in as large a quantity as possible, in order to protect their margins. This then creates the perception of shortages and drive prices still higher. In turn, it gives the outside world the illusion of robust demand. ‘Why else’ thinks the complacent observer, ‘would people be buying in such volume?’

It is only when prices finally stop rising that reality begins to dawn. Value chains are notoriously complex in this area, and it takes time for players to fully recognise that the perceived shortages were mainly driven by inventory changes. And only then do companies finally discover demand was actually reducing over the period, as cash-strapped consumers cut back on discretionary spending.

Worryingly, this seems to be the point we are reaching today. It is therefore probably no real surprise that companies are reporting increasing pressure on margins and volumes, and analysts are hastily starting to revise their 2013 growth forecasts.

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