The world is gripped in a global recession. Depending who you listen to, this will end early next year, or is only just beginning. The well-known cause of the crisis is too much borrowing by American home-owners - aided in turn by too great a willingness for banks to lend.



Now it's never that simple. Another little item that was causing hiccups just before the credit crisis burst was the price of oil - at $150 per barrel, it was causing consternation at the pump for drivers worldwide, difficult political decisions in places where governments keep petrol prices fixed through subsidies, and even protests and riots in one or two places.

Then came the credit crisis, and the price of oil dropped. Petrol prices are now at a much more comfortable figure.

The price of oil is sometimes quoted in the business news as if high prices are good. Perhaps for people who enjoy business news it is. For example,

  • If you own shares in oil-based investment products, when the price of oil goes up, your shares go up. This is because you own a little bit of something that has increased in value.
  • In general, over the past few years, the price of oil correlates with general economic activity - when the economy is booming, the price of oil is up. When recession hits, the price of oil is down. We come to the conclusion - if the price of oil goes up, it means the economy is doing well.


If we then think "high oil price cause good economic times" the we have our head screwed on completely backwards. The truth is the other way round - when the economy starts rolling, it causes the price of oil to go up - in the short term, at least.

But the price of oil also affects the economy.

Think about any business - they buy products and services, including their employees' time, add value to it, and sell it on at a profit. If the cost of the inputs goes up, either their profit goes up, or they have to charge more. Charging more means fewer sales. EIther way, the company is less profitable.

What if the price of oil goes up? For most companies, this has no effect on the value of their output - unless they sell oil, or solar panels, or insulation. However, it does have an effect on the cost of their inputs - at the very least since energy is one of the inputs they buy. You can't run a manufacturing plant without machinery. You need an airconditioned store to keep retail customers shopping. You need electricity to run the servers on your web-based service. Something has to power the container vessels supporting your imports business, and you need fuel for your road trains. For the public also, higher oil prices add costs - at the very least, the cost of driving to work - and removes money they might have spent on more expensive Christmas presents.

None of this is good for the economy.

So we have what is called a negative feedback loop - at least in the short-term. A thriving economy pushes up oil prices, and high oil prices push down the economy. If it was as simple as that, we would expect to see slow economic growth accompanied by a slow upward drift in the price of oil.

It's not as simple as that. Oil can be traded in a relatively efficient market. In an efficient market, "the best predictor of tomorrow's price is today's price" - if the price of oil is going to go up and up and up, it will already be up, right now, today. When the economy begins to recover, the price of oil will rise sharply, causing shocks again like we saw in 2007. It will then dip sharply in response to those shocks. It may take some time to stabilise, as investors and speculators take time to learn how it all works now. All this will lend uncertainty to economies - companies can't promise prices for next year's manufactured steel if they can't be sure of next year's energy price. This will further slow the economy.

If the price of oil is 50 then 100 then 50 then 100, it is worse for the economy than if the price of oil is a steady 75.

So as well as the negative feedback loop slowing economic growth, we have this volatility. This is why the recovery will be slow.

But why does all this apply now, and not before? Why is the price of oil suddenly so important?

The simple reason is that all the easy oil is used up. The oil being drilled and searched for is deeper underground, further offshore, lower quality and generally more expensive to dig up, purify, and put in car engines. When the price of a barrel of oil was $20, it wasn't worth a second glance. The exploration leases would have proven worthless, and caused the share price of their owners to dip. When the price of a barrel of oil hits $100 or $200, they suddenly become valuable, providing a great return on investment. This is the logical outcome for a field so inaccessible that it costs $50 per barrel to get the oil out. 5 years ago it was worthless. Today it's interesting. In 5 year's time it may well be starting production.

Now, I don't subscribe to the "Olduvai Theory" "Peak Oil" school. Oil and Natural Gas are not our only sources of energy. They've just been the cheapest for a long long time. Soon they won't be. We'll still have plenty of energy being produced, it will just be more expensive.

Anyway, back to the price of oil. Why is it so important now? Why is it so sensitive to the economy?

The first reason is, simply, because demand for oil is not very sensitive - in the short term - to price. In the medium term, yes. But not the short term.

Let me ask you - if you woke up tomorrow, and learned that the petrol price had doubled, what would you change? My guess is not much. You would still go to work the same way, driving or whatever. There are adjustments you can make in the face of doubled energy costs - besides just showering for a few minutes less, the biggest impacts you can have on your energy bills are :-

  • You can catch a bus instead of driving, or ride a bike instead of catching a bus.
  • You can move house to live nearer your work, or change job to work nearer your home.
  • You can install solar panels on your roof, and try to keep your home energy consumption within what the panels produce.

All of these are effective, none of them can be done at the drop of a hat.

Likewise, if you are a business, and your electric company tells you that the bills will double, you'll still open the doors for customers - and try to smile at them while you worry how to make ends meet. Over the course of months or years, you'll find answers (or go out of business). Maybe close up a couple of retail stores and sell more online, or install more efficient air-conditioners... who knows.

In the medium-term, people and companies will adjust to high energy costs by using less energy. In the short term, they will adjust to them by spending more of their money on energy, and less on other goods and services.

This has always been the case. The change has been in the supply - and this is the second reason.

When there was plenty of oil, the amount of oil on the market went up with price. Oil producing companies would pump out more when the going was good. This is illustarted in the diagram below.

Supply and Demand curves for 20th century oil


The line marked "supply of oil" shows how the amount produced and the price of oil would go up together. The lines marked "Economy Strong" and "Economy Weak" show how the amount of oil consumed goes down when the price goes up, but not by much. These are called "Demand curves" the place where the demand curve meets the supply curve will shows both the price of oil, and the amount supplied or consumed.

As you can see, when oil producing nations can pump oil more oil when the price goes up, an improving economy only produces a small change in the oil price. This was the situation last century.

Now, things are different. oil producing nations might want to pump out more when the price is high, but they can't.

Supply and Demand curves for 21st century oil

Notice that if the price goes up, the supply only goes up a little bit. Notice also that the same change in the demand curve - from a weak economy to a strong one - produces a large change in the price of oil.

Hence, a growing economy will push the price of oil up much more than it did in the past, forcing businesses to slow their growth, the public to spend less on other things, and (in the medium- and long-term) find ways to live with less - or alternative - energy.