Oil Price Posing a Risk at a Vulnerable Time

February 16, 2012

The possibility of a disorderly Greek sovereign debt default leads just about everyone’s list of economic growth risks.  Greece constitutes a small element in the European and global economies, but the potential danger is magnified by scope for speculative attacks on other vulnerable member countries including Italy and on Greece’s main creditors, a who’s who of world financial institutions.  Greece continues to get massive daily attention in financial market circles.  To be sure, doubts have arisen that maybe the contagion if Greece leaves the common currency area and/or defaults will not be nearly as widespread and severe as feared.  A view is gaining traction that keeping Greece in the union will inflict greater damage than cutting it loose now from the pack.  Before authorities and other big financial institutions let Lehman Brothers fail in September 2008, a similar view took hold, namely that it would be good for preserving self-discipline in banking if a big player were allowed to fail.  With hindsight, the permitted demise of Lehman was not an acceptable gamble to take in the fall of 2008, but no two crises are identical.  Only by taking the euro out of Athens will it be understood just has analogous this situation is to the decision about Lehman Brothers.

Greece is not the only big risk facing the world economy, however.  Many dangers fall regrettably  into the category of unknown unknowns.  They just happen without warning or foresignt.  Two examples in the early spring of 2011 — a chain reaction of revolution in the Middle East and North Africa plus Japan’s Sendai earthquake — wreaked considerable havoc, limiting growth for the year to 1.7% in the United States, 1.5% in Euroland, and negative 0.9% in Japan.  A spike in oil prices this year, by contrast, would not be a complete surprise but could be just as damaging as the twin surprises of 2011.  Just last month, the IMF warned that losing Iranian oil could lift crude prices by as much as 30%, and the saber-rattling between Iran and the West continues to intensify without any mutually suitable diplomatic means to defuse the dispute.

The IMF warning is credible.  Iran is the fourth largest world producer of oil and the second biggest within OPEC after Saudi Arabia.  Even with the possibility of losing Iranian supplies, oil is following a long-term upward trend.  The price of West Texas Intermediate crude averaged $19.36 per barrel in 1987-1999.  The period average price roughly doubled to $39.62 in the ensuing seven years to 2006 and doubled against to a mean value of $82.73 per barrel since the start of 2007, a span of a slightly more than five years ago. 

The table below illustrates how elevations in the cost of oil has been a reinforcing depressant since the world financial crisis began in 3Q07.  Oil prices were already on the rise before that summer and inclined more rapidly by 65.5% from a mean of $74.93 in 3Q07 to $123.99 in 2Q08.  The price averaged almost as high in the third quarter, peaking above $140 just two months before the Lehman collapse.  While not the main cause of the Great Recession, expensive energy prices contributed in a substantial way to the downturn’s severity. A later run-up in oil in the first half of 2011 also helped to depress growth in the second half of the year.  Figures in the table below are period average dollar price for a barrel of West Texas Intermediate crude.  The entry for 1Q12(*) covers through the first quarter through today.

U.S. Dollars 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter
2007 $58.28 $65.14 $74.93 $90.48
2008 97.64 123.99 118.34 59.13
2009 43.24 59.68 68.19 76.15
2010 78.81 78.07 87.14 85.28
2011 94.63 102.30 89.50 94.12
2012 99.89*      

U.S. economic trends have improved this winter, and Euroland’s contraction hasn’t intensified as feared.  But balance sheet adjustments by households and governments make this a sub-normal business cycle at best.  With or without Greece in the common currency area, prospects for several more years look pretty bleak, and the greatest risks to the most likely scenarios are skewed to the downside.  Dangers oftentimes are multiplicative, that is if more than one growth depressants strike at the same time, the result is worse than merely the impact of the two factors happening without the other.  Greece naturally should continue to draw considerable attention, and developments in Iran will be another critical determinant of what kind of year 2012 becomes.  Look out if both factors play out poorly.

Copyright 2012, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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