The first Organization of the Petroleum Exporting Countries (Opec) oil price shock in 1973 did a lot of damage to the world economy. But we are not living in 1973 anymore. Oil price moves have a smaller economic impact than they used to. We do not believe that the recent oil price increase (before the coronavirus outbreak in China that has now spread to 20 countries) is likely to last. But the rise does give an excuse to revisit oil’s lower economic importance.
One reason that oil is less economically important is that it is just less important overall. The world economy is more efficient in using oil. It takes less oil to make things today than it did in the past.
Chart 1 shows how much oil is needed for an economy to make a unit of real GDP. The indices show that on average an economy needs less than 40% of the oil it needed in 1970 to make something. Economies are more energy-efficient today. Alternative energy has replaced oil as a new economic power source. (Alternative energy has not reduced the demand for oil in terms of barrels consumed but it has reduced the “market share” or intensity of use of oil in the economy. New energy demand is more likely to be met with non-oil supply.)
More economic activity is due to services, which tend to need less energy. It is also worth noting that countries need less energy to make things than they did in 2010. The last big rise in crude oil prices was in 2010.
Emerging markets have also cut the amount of oil needed to make a unit of economic output (see Chart 2). The falling economic importance of oil has taken place mainly this century. Emerging markets have increased the number of barrels of oil they use. However, the economies have grown faster than oil use. This is why the oil price is less important to these economies. (In thinking about the economic importance of oil, it is the contribution of oil to economic output that is relevant — hence the indices of oil to GDP. If there were an oil embargo or some other supply shock that meant oil was not available, then the absolute volume of oil consumed may be a relevant measure.)
Oil revenues are spent, not saved
Another reason an oil price rise matters less today is that oil producers have learnt to spend money. A price rise simply transfers more money from buyers to sellers. What matters to the economy is what the sellers do with their additional money. In 1973, oil producers saved most of their new money. Almost three quarters was saved. That meant that money was being transferred from spenders (oil buyers) to savers (oil sellers). Global savings went up. Global spending went down. This was not good for the economy.
Now, oil producers spend most of their money (see Chart 3). In 2011, almost three quarters was spent. Total global demand should not fall with an oil price rise. Certainly, total global demand is unlikely to fall as much as it did in the 1970s. The pattern of demand may be different. Oil sellers may buy different things. But the total economic shock is a lot lower.
Consumers get inflation wrong — which matters
So, can we ignore oil entirely? Not really. Oil price rises do still hurt consumer behaviour. Consumers, generally speaking, are not very good at understanding inflation. When economists think about inflation, they use thousands and thousands of different items to get a number. Consumers do not do this. Consumers remember the price of things that they buy regularly. They forget about the lower price of the washing machine that they bought two years ago. Consumers’ view of inflation is driven by high-frequency purchases. Economists call this “frequency bias”.
What do consumers buy most frequently? Food and fuel. In the US, consumers’ view of inflation is very strongly tied to the price changes of food (eaten at home) and fuel for the car (see Chart 4).
Every time combined food and fuel prices have risen in the US, consumer expectations of overall inflation have risen in the US. If oil prices were to rise for some time, consumer expectations of inflation would almost certainly rise. Overall inflation may not change very much — but consumers do not think about overall inflation. In the mind of the consumer, inflation is all about the cost of fuelling the family fleet of sport utility vehicles. For a country such as the US, where petrol is not taxed very heavily, the link between crude oil prices and consumer oil prices is strong. That makes the link between crude oil prices and consumer inflation expectations strong.
The last oil spike happened in 2010, when US labour markets were weak. Consumers could not do very much about their (mistaken) view that inflation was around 6%. Now, labour markets are stronger. If oil prices lead consumers to mistakenly think inflation is rising again, they may try and push wages higher.
The one area in which oil does matter is inflation expectations. Consumers do not think about inflation the way economists think about inflation. In the unlikely event that oil prices do remain high, investors should watch wages a little more carefully.
Paul Donovan is chief economist at UBS GWM