Magazine article Business Review (Federal Reserve Bank of Philadelphia)

The Macroeconomics of Oil Shocks

Magazine article Business Review (Federal Reserve Bank of Philadelphia)

The Macroeconomics of Oil Shocks

Article excerpt

During the first quarter of 2002, the price of crude oil averaged $19.67 per barrel. Four years later, in the first quarter of 2006, the average price of oil had risen to $63 per barrel. Indeed, the high price of oil may not be a short-lived phenomenon: Futures markets indicate that investors expect the price of oil to remain above $70 per barrel through 2008. For the postwar U.S. economy, the data show a clear tendency for oil-price spikes to precede economic downturns. Though most of these episodes occurred at a time when oil's share as an input into U.S. production was larger than it is today, there is still much debate about how oil prices affect the economy. How concerned should we be about the economic consequences of persistently high oil prices?


Oil prices matter for the economy in several ways. Changes in oil prices directly affect transportation costs, heating bills, and the prices of goods made with petroleum products. Oil-price spikes induce greater uncertainty about the future, which may lead to firms' and households' delaying purchases and investments. Changes in oil prices also lead to reallocations of labor and capital between energy-intensive sectors of the economy and those that are not energy-intensive.

For these reasons and others, oil-price increases may lead to significant slowdowns in economic growth. In the postwar U.S. data, the correlation between oil-price spikes and economic downturns is not perfect--some oil-price increases are not followed by recessions. But five of the last seven U.S. recessions were preceded by significant increases in the price of oil. The most recent rise in the price of oil has not led (at least not yet) to an economic recession, but history nonetheless suggests that oil prices are an important element in assessing the economy's near-term prospects.


From the late 1940s to the early 1970s, the price of oil was very stable, moving up only slightly. (1) From the early 1970s to the early 1980s, the price of oil rose dramatically in a sequence of steps associated with the rise of OPEC and disruptions in the supply of oil from the Middle East oil-producing countries (Figure 1). (2)


OPEC first experienced the power it had over the price of oil during the Yom Kippur War, which started in October 1973. As a result of U.S. and European support of Israel, OPEC imposed an oil embargo on western countries. Oil production was cut by 5 million barrels a day (though about 1 million barrels a day in production was made up by other countries). The cutback amounted to about 7 percent of world production, and the price of oil increased 400 percent in six months.

From 1974 to 1978 crude-oil prices were relatively stable, ranging from $12 to $14 per barrel. The next big round of oil-price increases came with the Iranian revolution and Iran-Iraq war in 1979 and 1980. World production fell 10 percent, and this resulted in the price of oil rising from $14 to $35 per barrel. However, the high price of oil was leading consumers and firms to conserve energy. Homeowners insulated their houses. Commuters bought more fuel-efficient cars. Firms bought equipment that was more energy efficient. High oil prices also led to increased exploration and production of oil from countries outside of OPEC. From 1982 to 1985 OPEC sought to stabilize the price of oil through production quotas, but conservation efforts, a global recession, and cheating on production quotas by OPEC members eventually led to a plummeting of oil prices to below $10 per barrel by 1986. (3)

Since the mid-1980s the frequency of oil-price changes has been much greater than in the past. OPEC continued to influence the price using production quotas, but it has been unable to stabilize it. In fact, OPEC's share of world oil production has fallen from a peak of 55 percent in 1973 to about 42 percent today. …

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