Effects of high oil prices

Francesco Lippi, professor of economics at the University of Sassari, has an article on VoxEU.org in which he looks at the effects of the recent high oil price. The column, Oil prices: risks and opportunities, points out that

High oil prices are back – more than $125 per barrel. Such prices are associated with the macroeconomic pains of the 1970s, but this column argues that the recent surge may actually be good news for developed economies’ industries. The logic lies in the difference between demand shocks and supply shocks.

Lippi goes on to say

Economic theory suggests that the real effect of an oil price increase depends on its underlying fundamentals. If it stems from a change in supply conditions – as was the case with the Iranian revolution, the first Gulf war, or policy tightening by OPEC – the resulting price increase depresses economic activity, as energy inputs are more expensive. But if higher oil prices stem from increased demand by emerging economies, production in other economies like the US is subject to both a negative effect – due to the higher price of energy – and to a positive effect – greater demand for US goods and services by the growing emerging economies. According to this scheme, the weak relationship between oil prices and the US business cycle in recent years reflects oil demand shocks, while the episodes in the ‘70s and ‘80s can be ascribed to oil supply shocks.

Lippi then refers to a recent paper he co-authored with Andrea Nobili (“Oil and the macroeconomy: a structural VAR analysis with sign restrictions”, di F. Lippi e A. Nobili.) in which they examin the roles of oil demand and supply shocks in US industrial production for the period 1973-2007. The paper aims to identify the oil demand and supply shocks underlying fluctuations in oil prices (deflated by the US CPI). This allows them to estimate the effects of these shocks on the US business cycle. Importantly the identification strategy assumes that oil production and price move in opposite directions following a supply shock, while they move in the same direction following a demand shock.

The analysis shows that over the last 30 years oil demand shocks drive more than half of the oil price fluctuations with, therefore, supply shocks accounting for less than half. The analysis also shows that demand shocks are the main cause of the current price increases.

Lippi then asks: What are the effects of oil shocks?

The effects of oil demand and supply shocks on the US economy are markedly different. The left panel of Figure 2 shows that after a negative oil supply shock (that reduces production and increases the oil price), US industrial production falls (from the baseline trend) with an estimated probability of about 80% one year after the shock (the red line denotes the median response). After an oil demand shock causing a comparable increase in the price of oil, industrial production increases with an estimated probability of about 70% one year after the shock (see the right panel of Figure 2). Despite the “negative” production effect stemming from the higher oil price, the booming emerging economies ultimately lead to an increase in US industrial production the majority of the time.

Figure 2 Response of US production to oil mkt shocks

Note: US industrial production. The figure reports the 16th, 50th and 85th percentiles of the impulse response function distribution.

In Lippi's view the risk and opportunities associated with this can be summarised as

The emergence of new players in the global economy makes some resources scarcer, increasing their cost, but it also offers new trade opportunities. The positive correlation between the price of oil and US industrial production shows that the US economy enjoys a net output gain from these developments. Our study suggests that America’s specialisation in the production of goods not supplied by emerging economies is key to this result. It is the ability – or lack thereof – to innovate and produce goods that are not easily substitutable that determines whether the new challengers represent a risk or an opportunity for industrialised countries.