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Thesis & Antithesis

A critical perspective on energy, international politics & current affairs

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greekdefaultwatch@gmail.com Natural gas consultant by day, blogger on the Greek economy by night. Trained as an economist and political scientist. I believe in common sense and in data, and my aim is to offer insight written in language that is clear and convincing.

27 June 2006

How vulnerable to oil prices?

The most surprising feature of the current oil crisis is that it does not really feel like a crisis. Oil prices may be high and many people are struggling to cope with rising energy bills, but at a macro level, the world’s largest economies have registered solid growth in the past two years. That the global economy continues to grow despite high energy prices contradicts our assumption that higher energy prices ought to slow down growth, if not force a recession. Yet this reality has not provoked a corresponding change to our attitude towards energy prices. Hardly do we revisit the most basic, and pervasive, of our images about energy, and hardly do we question whether the commonly presumed link between oil prices and economic growth is true. A serious study of our ability to cope with high oil prices requires a prior examination of whether oil prices affect economic growth.


Figure 1 shows real GDP growth in 2004 and 2005 for the world’s twenty largest economies (corresponding to 80% of world GDP and 77% of energy use; methodology at end of article). Without an exception, all grew in both years. This is remarkable: Brent spot oil prices in 2003 were $30.62, in 2004 $39.57, and in 2005 $54.52. Despite this rapid increase in oil prices, many economies have shown significant gains; and the most sluggish among them (chiefly Germany, France, and Italy) face problems that go much beyond high oil prices.

What explains this counterintuitive fact—that countries grow despite high oil prices? One hypothesis is that energy intensity, the amount of energy required to produce a unit of GDP, has decreased gradually thus allowing countries to grow with less energy. Although this is indeed the case, a survey of the years 2004 and 2005 shows how difficult it is to establish a positive link between energy intensity and economic growth (figure 2). Theory would suggest that this relationship should be reflected in a downward slope—the more energy intensive an economy, the less it grew. This is not the case; in fact, there is little correlation, at least for these twenty economies in these two years.

At the same time, growth slowed somewhat in 2005. Figure 3 plots economic growth in pairs for the years 2003, 2004 and 2005: the x-axis gives the first year, and the y-axis gives the second (e.g. the green triangles show economic growth for 2003 in the x-axis and for 2004 in the y-axis). The 45-degree line shows parity—any data point on that line had similar economic growth for two successive years; data over the line experienced higher growth in the second year of the pair, and data under the line registered a slowdown in growth. In 2002-2003, growth varied considerably; in 2003-2004, however, most of the countries showed increased growth, even though oil prices were much higher. In 2004-2005, about half of the countries were experiencing equal growth as in 2004, and the rest registered a slowdown, albeit a small one.


What to make of these numbers? One hypothesis about the resilience of economies to high oil prices traces the reason to energy intensity. In a way, energy matters less today since countries need less energy to produce wealth; therefore, they can grow, even as energy prices soar. Even though there is no correlation between energy intensity and economic growth, a shift has taken place and the level of energy intensity is so low that countries can grow almost independent of it.

Taking this idea one step further is the notion that the link between high oil prices and economic growth was never strong to begin with. This idea has several proponents who have sought and failed to find definitive empirical linkages between oil price movements and changes in growth in the United States. (See Robert Barksy and Lutz Kilian, “Oil and the Macroeconomy Since the 1970s,” Journal of Economic Perspectives, Fall 2004.)

Perhaps what distinguishes today’s energy environment is that the rise in oil prices, while dramatic, has been orderly, much smoother than either the 1973 or 1979 oil shocks. This time, the rise has been demand-driven, primarily as marginal demand has outpaced marginal supply, owing largely to lagging investment, although abetted by fears about disruptions, geopolitical or natural. Today’s prices have they have risen to high levels because consumers have been willing to pay for expensive oil. Not so in the past, when prices rose because of shortages or explicit changes in posted prices.

Figure 4 illustrates this point, even though it does so crudely. On the x-axis is plotted real GDP growth in 2005 and the y-axis plots the difference in 2005 and 2004 growth rates (1% means that the GDP growth rate in 2005 was 1% higher than in 2004). This figure looks anew at figure 3, essentially asking the question: which countries can afford to pay high prices and are less likely to be affected by them? The answer is the countries that are growing faster, even though the proof is intuitively derived from the graph rather than proven mathematically.

Given that today’s markets are also much more responsive to supply and demand dynamics than they were in the 1970s, variations in demand lead producers to adjust prices much more rapidly than in the past. This indicates that high prices will remain as long as there is demand and that if a recession were to follow, demand for oil would come down along with its price. This may appear intuitive, but it is quite the opposite from the assumption that oil prices cause recessions rather than respond to underlying macroeconomic conditions. Alarming as the rise in prices has been over the past few years, we are still far away from understanding precisely how higher oil prices affect economic growth.


Annual GDP growth estimated from figures in the country database of the Economist Intelligence Unit (EIU). Energy intensity calculated as: energy consumption in million tons of oil equivalent (using numbers from the BP Statistical Review of World Energy 2006) divided by the GDP (PPP) of that year.

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