Be careful what you wish for: Higher oil prices and slow growth may make for a perfect storm

Sudeep Reddy, an economics editor at the Wall Street Journal, claims “we are one shock away from a recession and it’s not going to take a lot. … We have not set up the infrastructure or the policy to respond to [large shocks] and won’t really know how to deal with it till long after it has arrived.”

Could that shock be an unexpected rise in oil prices?

Low oil prices have helped the world put its foot on the gas…

Low oil prices should have helped the eurozone out of its economic malaise, and Americans to finally benefit from the United States’ slowest ever recovery from recession. Consumers in the two economic powerhouses were supposed to have started consuming, giving Chinese exporters and employers an early shot in the arm and dragging Chinese growth back up to levels seen in happier days. At the same time, the low price of the sticky stuff should have helped producers cut costs and bolster wages and profits. The IMF estimated that low oil prices would boost worldwide economic growth by half-a-percentage point in 2015–16 at a time when oil was trading at around $65 a barrel. Oil prices have since halved.

…But the economic motor isn’t running any faster

Alas, the benefits have not rolled in. In January, 2016, the IMF saw a “more gradual recovery” than it did in October 2015. The World Bank sees the global economic recovery as “slow-moving” and with “risks … tilted to the downside” even of this poor performance. Emerging markets from Brazil to South Africa to Turkey to Russia face particularly trying times, and Chinese growth has slowed.

Yet, the U.S. and eurozone economies were in such a funk that low oil prices were never going to be a magic pill. Household debt is still being unwound in the U.S., and in most European countries it has hardly fallen since the start of the crisis. Public debt has increased fast in almost all OECD countries, and risks abound all over the EU—from Italy’s debt to the U.K.’s referendum on membership, from the refugee crisis to Spain’s uncertain government. Plus Greece. Outside the EU, Paul Krugman reckons Abenomics may fail in Japan.

Some say oil prices will stay low for a decade. But what if they don’t?

What happens if the cheap gas runs out now?

The extremely low oil prices may themselves be partly to blame for the world’s poor economic performance. Investment and jobs in the oil industry are being cut, and trouble in oil-producing economies spells uncertainty for countries that export to them, and for investors in their companies or their governments’ bonds.

But be careful what you wish for. The IMF reckons that the fall in oil prices may yet provide a stronger boost for oil importers than it has so far, and some of the gains may not yet be clear, having been offset by other negative shocks. However, some benefits are already being clearly felt: U.S. consumers are consuming around 80 cents of every dollar saved on gas and even sales of gas-guzzling cars are ticking up. Several emerging economies have been able to cut energy subsidies, shaving a small amount off the $5 trillion the world spends subsidizing energy.

Higher oil prices could yet hurt. Indeed, oil price increases hit economies’ growth harder than declines benefit them. An oil price increase would pass through to consumers, with energy representing around 8 percent of the U.S. consumption basket and over 10 percent of the Eurozone’s. In the short term, around 40 percent of an oil price increase is estimated to pass through to consumers and around 80 percent in the longer term. This means that even a relatively modest rebound to $50 per barrel would result in around a 2 percentage point increase in inflation in the U.S. and a 3 percentage point increase in Europe, and more in the longer-term (assuming most energy prices follow that of oil). And these are only the first-round impacts, before producers pass all costs onto consumers and each other. Consumers would face higher prices before growth has taken off in the eurozone, before wage growth has set in in the U.S., and at a time of slowing growth in emerging markets. Producers would face higher costs at a time when business confidence is already below its long-run average. Emerging markets that have failed to remove energy subsidies may struggle with the higher subsidy bill.

A larger oil price increase or a higher pass-through could mean the return of stagflation. It could mean the perfect storm.

Is the perfect storm approaching?

Maybe. And it’s worth thinking about.

Despite the current glut of oil, (including up to 50 million barrels sitting off the Iranian coast waiting to be delivered), supply could contract for a couple of reasons:

• Saudi Arabia has already indicated that it would be willing to cooperate with other producers to constrain output, and some producers may be willing, including Russia, and U.S. production could continue its decline;
• While Iran plans to bolster production and exports, nothing is set in stone. Both Iran and the U.S. will hold elections during 2016, with some U.S. Republican candidates hostile to the deal. Understandably, while some companies are keen to invest in Iran, many are cautious, fearing the consequences of breaking sanctions (an $8.9 billion fine, in the case of BNP Paribus). Iran may not be able to attract the investment it would like, restraining oil production.

Oil markets could quickly “price in” the reduced supply. With markets tetchy in the current economic uncertainty, a steep and rapid price increase wouldn’t be out of the question.

What tools could fix the motor?

Our tools are worn. Public debt is high in most developed economies, making fiscal stimulus a risky option. Despite the Federal Reserve’s December increase, interest rates in developed economies are lower than ever, making a monetary stimulus difficult. Central Banks could engage in more quantitative easing, but in the eurozone that would depreciate the euro, further increasing the price of oil for domestic consumers. And, if inflation begins to take off at the same time as economies are pushed into recession – stagflation – options become even tougher.

Time to get our thinking hats on.