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Tuesday, May 26, 2009

It is the Oil Price Stupid!

The sub-prime crises might have been what precipitated the credit crunch, but it was arguably the high oil prices that first pushed the world towards recession by catalyzing the US slowdown at the end of 2007.

Whereas historical oil price shocks were primarily caused by physical disruptions of supply, the price run-up of 2007-08 was caused by strong demand confronting stagnating world production. According to a paper by James Hamilton of UC San Diego, although the causes were different, the consequences for the economy appear to have been very similar to those observed in earlier episodes, with significant effects on overall consumption spending and purchases of domestic automobiles in particular. In the absence of those declines, it is unlikely that we would have characterized the period extending from Q4 of 2007 to Q3 of 2008 as one of economic recession for the U.S. The experience of 2007-08 should thus be added to the list of recessions to which oil prices appear to have made a material contribution.

Of course the hand that takes can also give. The fall in oil prices has now helped the world economy to stabilize. In comparison to the stimulus provided by oil, government handouts are peanuts. Last year the world was consuming 88 million barrels per day at an average cost of $100 per barrel, at an annual cost of $3.2 trillion. If this year's average cost of crude oil around $50 per barrel holds up, the annualized savings will be about $1.6 trillion. The International Monetary Fund estimates that the fiscal stimulus to be provided by the G20 countries for this year and next will amount to $1.2 trillion at best, excluding bank bail-outs.

According to a just released report by the International Energy Agency( (IEA), global investment in oil and gas projects is expected to slump 21% this year from a year ago, falling for the first time in a decade.

More than 50 major oil and natural-gas projects around the world have been cancelled or delayed by at least 18 months since October, the IEA, the energy advisor to 28 major energy consuming countries, said in the report. According to the IEA, $170 billion worth of projects, involving around 2 million barrels a day of oil production and 1 billion cubic feet a day of gas output have been cancelled. In addition, 35 projects, involving 4.2 million barrels a day of oil capacity and 2.3 billion cubic feet of gas capacity, have been delayed by at least 18 months

With oil demand expected to rebound next year, following two consecutive years' decline, failure for oil production to keep up with a rising demand could drive up oil prices and put a nascent global economic recovery on screeching halt.