Oil Shocks and Economic Recessions

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I've just completed a new research paper that surveys the history of the oil industry with a particular focus on the events associated with significant changes in the price of oil. Here I report the paper's summary of oil market disruptions and economic downturns since the Second World War. Every recession (with one exception) was preceded by an increase in oil prices, and every oil market disruption (with one exception) was followed by an economic recession.

The table above itemizes the particular postwar events that are reviewed in detail in my paper. The paper also provides the following summary discussion:

The first column indicates months in which there were contemporary accounts of consumer rationing of gasoline. Ramey and Vine have emphasized that non-price rationing can significantly amplify the economic dislocations associated with oil shocks. There were at least some such accounts for 5 of the 7 episodes prior to 1980, but none since then.

The third column indicates whether price controls on crude oil or gasoline were in place at the time. This is relevant for a number of reasons. First, price controls are of course a major explanation for why non-price rationing such as reported in column 1 would be observed. And although there were no explicit price controls in effect in 1947, the threat that they might be imposed at any time was quite significant (Goodwin and Herren, 1975), and this is presumably one reason why reports of rationing are also associated with this episode. No price controls were in effect in the United States in 1956, but they do appear to have been in use in Europe, where the rationing at the time was reported.

Second, price controls were sometimes an important factor contributing to the episode itself. Controls can inhibit markets from responding efficiently to the challenges and can be one cause of inadequate or misallocated supply. In addition, the lifting of price controls was often the explanation for the discrete jump eventually observed in prices, as was the case for example in June 1953 and February 1981. The gradual lifting of price ceilings was likewise a reason that events such as the exile of the Shah of Iran in January of 1979 showed up in oil prices only gradually over time.

Price controls also complicate what one means by the magnitude of the observed price change associated with a given episode. Particularly during the 1970s, there was a very involved set of regulations with elaborate rules for different categories of crude oil. Commonly used measures of oil prices look quite different from each other over this period. Hamilton (2010) found that the producer price index for crude petroleum has a better correlation over this period with the prices consumers actually paid for gasoline than do other popular measures such as the price of West Texas Intermediate or the refiner acquisition cost. I have for this reason used the crude petroleum PPI over the period 1973-1981 as the basis for calculating the magnitude of the price change reported in the second column of Table 1. For all other dates the reported price change is based on the monthly WTI.

The fourth column of Table 1 summarizes key contributing factors in each episode. Many of these episodes were associated with dramatic geopolitical developments arising out of conflicts in the Middle East. Strong demand confronting a limited supply response also contributed to many of these episodes. The table collects the price increases of 1973-74 together, though in many respects the shortages in the spring of 1973 and the winter of 1973-74 were distinct events with distinct causes. The modest price spikes of 1969 and 1970 have likewise been grouped together for purposes of the summary....

These historical episodes were often followed by economic recessions in the United States. The last column of Table 1 reports the starting date of U.S. recessions as determined by the National Bureau of Economic Research. All but one of the 11 postwar recessions were associated with an increase in the price of oil, the single exception being the recession of 1960. Likewise, all but one of the 12 oil price episodes listed in Table 1 were accompanied by U.S. recessions, the single exception being the 2003 oil price increase associated with the Venezuelan unrest and second Persian Gulf War.

The correlation between oil shocks and economic recessions appears to be too strong to be just a coincidence (Hamilton, 1983a, 1985). And although demand pressure associated with the later stages of a business cycle expansion seems to have been a contributing factor in a number of these episodes, statistically one cannot predict the oil price changes prior to 1973 on the basis of prior developments in the U.S. economy (Hamilton, 1983a). Moreover, supply disruptions arising from dramatic geopolitical events are prominent causes of a number of the most important episodes. Insofar as events such as the Suez Crisis and first Persian Gulf War were not caused by U.S. business cycle dynamics, a correlation between these events and subsequent economic downturns should be viewed as causal. This is not to claim that the oil price increases themselves were the sole cause of most postwar recessions. Instead the indicated conclusion is that oil shocks were a contributing factor in at least some postwar recessions.

Posted by James Hamilton at January 15, 2011 08:18 AM

What do you make of the doubling in oil price since early 2009?

Given the growth rate in developing countries and the recovering of developed countries, oil is probably going to head higher.

Posted by: Joe at January 15, 2011 08:57 AM

Joe: According to the model developed in my 2003 Journal of Econometrics paper (working paper version here), oil prices wouldn't have the potential to induce another recession until after June of 2011. I do believe they can start to exert a drag on growth, however, as I described here.

Posted by: JDH at January 15, 2011 09:09 AM

How many times were there major price increases (however you define major) that were not followed by a recession?

Posted by: Art at January 15, 2011 09:59 AM

Loosely related, Freakonomics weblog has a post up on Peak Driving.

You already know my beliefs regarding this subject. The aging baby boom population and more people driving with children are probably contributing.

But I think there are oil/gasoline price responses that compound these problems and create a positive feedback loop. People driving more during more congested times for business to make up for shortfalls in income and driving less for recreation and leisure in off-peak times. People moving closer together overwhelming benefits of shorter distances...

Here is my comment I submitted:

Three things I believe are the primary causes are:

Inadequate road building and maintenance. Cell phone usage. Rising gas prices.

Rising gasoline prices decreasing our fleet efficiency is counter-intuitive, but it is very logical when thought through thoroughly.

Prior to the 2008 price spike, I believe there was a sort of Giffen Behavior happening, where people were driving more during congested times for business to make up for their shortfalls in income and driving less during off-peak times for recreation and leisure.

Accelerating too slowly. The common advice to drive economically is to drive as if there is a glass of water on the dash board. This is good advice for an individual driver, but it is flawed for a couple reasons.

One, it is great advice because it minimizes braking, which is the primary energy wasting behavior in driving. However, this advice is overly conservative on the acceleration side. When accelerating, smooth and quick acceleration is most efficient. Getting RPM a little above 3000 (for typical gasoline vehicles) is most efficient. Accelerating smoothly and quickly will be more efficient, provided the driver does not accelerate too much and then need to brake.

Second, while this advice is good for an individual driver, it does not consider the driver's effect on the system as a whole. Slow accerlation decrease through-put at bottlenecks. This is also why cellphone/smart-phone usage probably makes a large contribution to the increase in cogenstion we see, despite less driving overall. We end up with more stop-and-go. It's sort of like the tragedy of the Tragedy of the the Commons. Individuals trying to optimize their fuel economy (or time, in the case of phone users) degrades the economy of the system as a whole.

Posted by: aaron at January 15, 2011 11:32 AM

Art, he says in the post just one, the 2003 price rise. I think the reason is that before 2008 people still had hope their income situation would improve and borrowing was cheap.

Posted by: aaron at January 15, 2011 11:38 AM

Upward drive-time spikes would likely have an effect similar to energy price effects.

Posted by: aaron at January 15, 2011 11:43 AM

Professor JDH,

Good and timely job. Not al countries and not all economic sectors depend equally on oil prices. It should be nice to know a bit more specifically about the putative effects of oil hikes on households who in many cases are debt-strained. Another question is if, given that many manufactures are done in countries with low labor costs, increasing oil prices would potentially translate in relatively higher price increases in those manufactured goods (manufacturing energy costs may be relatively more important now than two decades ago).

Posted by: Ignacio at January 15, 2011 02:52 PM

Great work, thanks!

Posted by: Carl Lumma at January 15, 2011 03:08 PM

Dr. Hamilton, I recommend the Brookings Institute paper linked at the end of the Freakonomics post.

Posted by: aaron at January 15, 2011 03:49 PM

"Every recession (with one exception) was preceded by an increase in oil prices,"

There would seem to be some simultaneity at work in this result - namely, recessions are typically prededed by booms, which would tend to drive up the price of oil, since it has rather steep short run supply and demand curves.

Posted by: don at January 15, 2011 04:26 PM

The importance of oil to the modern economy can not be overstated ... Roughly 95% of transportation is driven with oil. There are NO scalable substitutes.

Both the supply and demand are very inelastic.

The supply takes years to develop and because of the huge investments in exploration, development and transportation there are created two phenomena ... The picking of first, the low hanging fruit, the best and largest deposits closest to easy transportation and markets. The second is the rapid depletion of developed oil to increase the ROI on these enormous investments.

The demand is also very inelastic ... especially transportation of goods. Huge investment both personally in cars and commercially in trucks, rail and ships are long term sunk costs. In the very short term dissavings will bridge this gap. In the medium and long term demand destruction will occur.

What we are facing now is threefold. First the underinvestment and corner cutting in oil production infrastructure as witnessed by the Alaskan Pipeline leak, the fires at Canadian tar sands production and the BP blowout in the gulf.

Second the depletion of all of the world's "low hanging fruit" oil deposits. New oil fields are smaller, contain less desirable oil,in locations where transportation is difficult and \or politically unstable.

Third, we have now moved oil futures onto markets where it is no longer producers and refiners that play but huge financial firms that have no stake in the actual oil itself ...