Oil Prices Re-enter The “Danger Zone”

Get ready for a prolonged slowdown in the major industrial economies.

If Brent crude oil prices stay substantially above $100 per barrel, the economies of the United States and Western Europe will almost certainly struggle in the next few months.

At no point in the last five years have U.S. manufacturing and the wider economy managed to expand strongly when international oil prices have been above $100.

In every case, prices above $100 have been associated with a loss of momentum as the Institute of Supply Management (ISM)’s composite manufacturing index has fallen back towards the 50-point threshold dividing expanding activity from a contraction.

This analysis is fairly crude and little more than a restatement of the familiar view that growth slows when the cost of oil in consuming countries (the “oil burden”) climbs much above four per cent of GDP.

It uses Brent rather than U.S. crude prices (also known as WTI) because seaborne, internationally traded Brent drives the cost of gasoline in the United States and around the world.

Rising oil prices boost input costs and squeeze incomes for firms and households, as well as heightening uncertainty and deterring spending on big ticket items.

The impact is rarely immediate. It takes time for the full impact of rising prices to be realised by consumers and businesses – several tank refills and months worth of operating costs before they appreciate the full hit.

While the analysis is simple, it helps pinpoint the threshold at which high prices start to have an adverse impact on economic growth.

Some analysts prefer to express oil’s impact in terms of the rate of change rather than an outright price level. University of California Professor James Hamilton has famously analysed slowdowns caused when oil prices surge above the previous peak set over the last one to three years.

On almost any timescale, current prices do not qualify as a Hamiltonian oil shock because Brent still remains below the record closing high set in July 2008 ($146) as well as more recent peaks in April 2011 ($127) and March 2012 ($126).

Even so, there is compelling evidence that prices above $100 have been associated with a loss of economic momentum.

It suggests the Hamiltonian focus on rates of change should be supplemented with an emphasis on absolute price levels.

At least in the current environment, it seems the major industrial economies struggle when prices rise much above $100. It is no accident that Saudi Arabia identified $100 as its target price earlier this year.