The Price of Oil: Is History Repeating Itself?
The price of oil has broken through $55 and continues to hit new highs. In fact,
oil prices have increased over 70% this year for three main reasons: there have been few
new discoveries of oil in recent years; there is greater demand for oil, especially from
China, who is now the world’s largest importer of oil following the United States; and
there is uncertainty over oil supplies because of war and terrorism.
In the past 30 years, higher oil prices were followed by recessions in 1973, 1981,
1990 and 2000. Higher oil prices have historically led to recessions because they act as a
tax on spending by absorbing consumer dollars that would be spent elsewhere, by
reducing corporate profits through increased costs and lower demand, and by causing
higher inflation which in turn causes higher interest rates.
Higher oil prices cause a supply shock that reduces GDP while simultaneously
raising inflation. This is what happened in the 1970s when the world was hit by
stagflation, and when accommodative policies by central banks pushed inflation and
interest rates even higher.
The oil shocks of the 1970s and 1980s had a devastating impact on investors. 10-
year US Bond yields rose from around 6% to 15% imposing losses on fixed-income
investors. Stock market investors also lost money. For example, the Dow Jones
Industrial Average lost nearly 75% of its value, after adjusting for inflation, between
1966 and 1982, its worse decline since the Great Depression. Depositors suffered because
interest rate controls prevented them from getting adequate returns on their deposits.
During the 1970s, there was no place to hide. Whether investors had their money
invested in stocks or bonds, they lost money. Should investors today have the same
Why 2004 Is Different From 1973 and 1981
The impact of higher oil prices on the economy and on investors is more complex
that it would first appear. That is why taking a full global and historical perspective on
the price of oil is important. By looking at historic oil prices, stock prices, interest rates,
inflation rates and other financial and economic data in the Global Financial Database,
we can provide some analysis to help investors.
Increases in oil prices impact some economic sectors more than others. Investors
need to change their sector allocations in response to higher oil prices. Oil stocks, for
example, have been breaking out to new highs for the past two years. This also happened
in the 1970s when oil prices increased previously. Oil stocks outperformed the rest of the
market between 1973 and 1980 when the price of oil was rising, but underperformed the
rest of the market between 1980 and 2000 when oil prices declined. A continuation of
strong performance in the oil stocks will depend upon whether the price of oil continues
on this uptrend.
Additionally, investors should consider the impact of higher oil prices on other
sectors. The airline and auto industries, which are heavily dependent on oil, have faltered
during the past two years, just as they did in the 1970s. Internet retailers, such as
Amazon, should benefit from higher oil prices because consumers won’t drive as much as
they used to.
The impact of higher oil prices on the stock market is smaller than in the 1970s.
Energy costs’ share of GDP has fallen from 8% in 1973 to only 2% today. The global
economy relies more on services today than in 1973 and higher oil prices have made the
world more energy efficient. Increased demand from China has contributed to the rise in
commodity prices, including oil, during the past five years. China needs more oil to
produce the vast amount of goods it is exporting to the rest of the world. Though oil
prices are higher, Chinese exports have reduced the price of manufactured goods
benefiting consumers throughout the world. Every change in the global economy has
costs and benefits and the key to successful investing is to determine where those costs
and benefits occur.
To measure the overall impact of China’s entry into the world economy, you have
to look at the impact on both commodities and manufactured goods. China has moved
the terms of trade in favor of countries exporting commodities and importing
manufactured goods, such as Australia, while moving the terms of trade against countries
importing commodities and exporting manufactured goods, such as Bangladesh.
This trend is likely to continue. Therefore, investors should be aware of the
impact this will have on the price of equities. Investors should increase investments in
countries, such as Australia, that benefit from higher commodity prices and lower prices
for manufactured goods while reducing investments in developing countries that must
import oil and compete with Chinese exports.
One surprising difference between 2004 and the 1970s is that despite higher oil
prices, interest rates have not increased. Typically, a supply shock both raises prices and
reduces output; however, this time inflation has not risen significantly, and long-term
interest rates have actually fallen.
Lower interest rates signify that the inflationary impact of higher oil prices will be
minimal. The bond markets do not expect the higher oil prices to trigger an inflationary
spiral similar to the 1970s. The good news is that fixed-income investors need not fear
the impact of higher oil prices on bonds as much. The smaller role of energy costs in
GDP, the larger role of services, and the deflationary impact of greater manufactured
exports from China along with less accommodative monetary policy have reduced the
inflationary impact of higher oil prices.
The supply and demand for oil are both inelastic in the short run causing the price
of oil to be volatile. This explains why the price of oil can increase by 70% since
December 2003. Changes in the supply or demand for oil can cause dramatic shifts in the
price of oil, either higher or lower.
Higher oil prices spur more exploration for oil, increase the demand for oil
substitutes, and encourage oil conservation. Historically, oil prices have increased
sharply, and gradually declined as supply caught up with demand. Oil prices increased
rapidly in the 1860s, the 1910s and 1970s only to be followed by declining prices in the
decade that followed these periods. This is because the supply and demand for oil are
more elastic in the long run, making the price of oil more stable in the long run.
Oil prices have been rising since 1999, but the impact has been quite different
from the 1970s. For the reasons given above, the impact of higher oil prices on investors
is likely to be less severe than in the 1970s. Also considering the behavior of inflation
and exchange rates in the past, we will see that history reinforces this conclusion.
Adjusting for Inflation
At $55, the current price of oil is at an all-time high, but what happens if you
adjust for inflation? Or what happens if you look at the cost of oil in Euros or in Yen?
To adjust for inflation we converted the historic price of oil into 2004 prices. We
found that the average price of oil during the 20th Century, as measured in 2004 prices,
was $23. The real price of oil fluctuated between $10 and $20 until the 1970s when the
first oil crisis hit. Since 1973, the average real price of oil has been $38.
After 1972, the price of oil increased more than five fold, rising from $15.50 in
1973 to over $83 in 1981 as measured in 2004 prices. The price of oil slid for the next 17
years, bottoming out at $13 per barrel in November 1998. Adjusting for inflation, this
was the lowest the price oil had been since the 1940s.
Since November 1998 the price of oil has risen steadily from $11 in 1998 to $56
per barrel today. There was an initial increase in price between November 1998 and June
2000 when oil rose to $35 per barrel, and a second increase from November 2001 when
oil rose from $20 a barrel to $55 today.
Although the current price of oil is at an all-time high, after adjusting for inflation,
oil is still cheaper than it was in 1981. In fact, the price of oil would have to increase by
50% from its current price of $55 to return to the equivalent of its 1981 levels. Given the
psychology of markets, if the price of oil were to increase to $83 a barrel, what would
keep it from going to $100?
Nevertheless, at $55 the current price of oil is 50% higher than the average price
of oil since the oil shocks of 1973. Oil prices have been rising for six years now, which
is above its long-term average. Although the price of oil could still rise further, in the
longer term the price of oil is more likely to retrace to the $30 range. Looking at the
historical behavior of the price of oil, it would appear that most of the increase in the
price of oil has already occurred, and probabilities favor that five years from now the
price of oil is more likely to be below today’s price than above it.
Oil Price $/Barrel
Year Nominal 2004 Prices
1900 0.45 11.35
1910 0.53 10.85
1920 3.5 34.19
1930 0.95 11.18
1940 1.02 13.71
1950 2.57 19.48
1960 2.97 18.89
1970 3.41 16.24
1975 13.37 45.65
1980 35.53 78.02
1985 26.53 46.00
1990 28.44 40.28
1995 19.54 24.12
2000 26.72 29.10
2004 56.37 56.37
The Price of Oil in Europe and Japan
Although the price of oil is set in US Dollars, the cost of oil in Europe and Japan
also depends on exchange rate movements. We calculated the price of oil in two
currencies, the Euro (using the European Currency Unit before 1999) and the Yen. The
results are quite interesting.
European currencies appreciated relative to the US Dollar in the 1970s, reducing
the economic impact of higher oil prices. The price of a barrel of oil rose from around 3
Euros at the beginning of 1973 to 25 Euros by the summer of 1980. Although the US
price for oil peaked in February 1981 at $38, the decline in the value of European
currencies meant that the cost of oil continued to rise until 1984. Oil rose from 32 Euros
in February 1981 to 40 Euros in September 1984. The price of oil increased by 20% in
Euros during those three years, but fell by 30% in US Dollars. The price declined to
around 11 Euros per barrel by March 1986 and remained under 20 Euros until 1999.
The strength of the Euro in the past few years has meant that the rise in the Euro
price of oil hasn’t been as severe as in the United States. A barrel of oil hit 38.50 Euros
($33.60) in November 2000, and rose to 44.20 Euros ($56.37) in October 2004. Oil has
risen 70% since November 2000 in Dollar terms, but only 15% in Euro terms.
The price for oil may be at all-time highs in Europe and the United States, but not
in Japan. A barrel of oil cost around 1000 yen in 1972 and rose to over 9000 yen by
October 1982. As the Yen strengthened after October 1982, the price of oil in Japan fell.
By July 1986 oil had fallen to around 1750 yen, only 75% above its level in 1972. This
fact can partly explain why Japanese manufacturing was so strong relative to the rest of
the world in the 1980s.
The price of oil increased 400% in the US and Europe between 1973 and 1986,
but it increased only 150% in Japan because of the strength of the Yen. Further strength
in the Yen meant that by the end of 1998, a barrel of oil cost only 1400 Yen, only 40%
higher than the price in 1972! Today, the price of oil is about 6000 yen, which is still
lower than the yen price in 1982.
The important point to note from this review is that only looking at the Dollar
price of oil can be misleading. As the table below shows, changes in the price of oil look
quite different when viewed in Euros or Yen rather than in US Dollars. This is another
reason why the impact of higher oil prices on the world economy is likely to be weaker
now than it was in the 1970s and 1980s.
Month Dollar Euro Yen
Dec. 1972 3.51 3.19 1060
Feb. 1981 38.34 32.12 8040
Oct. 1982 33.01 35.97 9150
Sept. 1984 29.65 40.22 7320
Jul. 1986 11.38 11.26 1750
Sept. 1990 39.58 30.09 5480
Nov. 1998 11.37 9.8 1400
Nov. 2000 33.61 38.53 3700
Oct. 2004 56.37 44.20 6020
Investors are concerned about the daily increases in the price of oil to new highs.
Yet the impact of higher oil prices on the prices of financial assets in 2004 has been
surprisingly weak compared to the 1970s. Let’s summarize some of these reasons.
First, proven oil reserves are actually greater today than they were in 1973 when
the first oil crisis hit. Despite higher oil prices, there are no unrealistic fears that the world
is running out of oil as in the 1970s. Long-term interest rates have not risen this year
indicating that the bond market considers the rise in the price of oil to be short lived.
The biggest problem for oil is the concentration of reserves in the Middle East.
Although proven oil reserves are greater than they were 30 years ago, reserves remain
heavily concentrated in the Middle East and disruptions to oil supplies resulting from
conflict in the Middle East are the primary concern for traders. This is the so-called
“terrorism premium” that is built into the price of oil.
Second, the current rise in the price of oil has not been accompanied by increases
in the prices of other commodities as in the 1970s. Inflation in the price of food, metals
and other commodities remains subdued, so the overall inflationary impact on the
economy is smaller. This helps to explain why we have not suffered as much inflation as
in the 1970s and why interest rates have remained low.
Third, oil now represents 2% of global GDP, not the 8% it represented in 1973.
Higher oil prices give people an incentive to make more efficient use of oil. Moreover,
the global economy has moved toward more services and information technology and
away from manufacturing.
Fourth, prices are relative. Even at $55 a barrel, after adjusting for inflation, the
price of oil is still 30% below its price in 1982. The price of oil would have to rise to $83
to match the 1982 price. The real price of oil is above its historical average giving
businesses an incentive to search for oil substitutes. This also gives businesses an
incentive to search for new oil reserves. As this occurs, the price of oil will fall.
Fifth, in nominal terms, the Euro price for oil has only increased by 15% in the
past four years while the US Dollar price has increased by almost 70%. The Yen price of
oil is still below its level 20 years ago. The strength and weakness in the price of the US
Dollar also influences the cost of oil.
Sixth, one reason for the increase in the price of oil is greater demand from China.
At the same time, exports from China have a deflationary effect on manufactured goods,
which offset the inflationary effect on commodities such as oil. Countries that import
manufactured goods and export commodities will strongly benefit from this effect.
Developed countries that import oil and export manufactured goods will suffer the most
from these changes.
By studying the historical behavior of financial assets we now have a better
understanding of what the future is likely to hold. The evidence we have presented and
reviewed leads us to believe that the impact of higher oil prices on stocks and bonds
should be limited, barring a severe disruption of oil supplies from the Middle East.
Although the price of oil could still rise in the short run, the price of oil is more likely to
decline during the next few years than to rise.