Tuesday, January 22, 2008

Fear of recession brings lower oil prices

The New York Times reports that oil prices dropped to $89.15 recently. Apparently energy investors view the economy as an indicator of oil demand. So, as the economy slows, oil future prices will decline due to the expected decline in consumption. The article lists gasoline and heating oil as examples of petroleum products for which demand will lower.

This is confusing to me. Although I understand that increased costs means decreased demand, I would think (for petroleum) that demand would fall for plastic products or other nonessential petroleum products. Is the market for products such as gasoline and heating oil really that volatile? At this time of the year when the weather is coldest and after the holiday travel rush, I would think the demand for these products would be relatively steady.

Another interesting note in this article is the close link between oil prices and the economy. Though many events combined to bring on this "fear of a recession" (we won't know if it really was a recession until after the fact), but this article reports that high oil prices were partly to blame as well. This close relationship between the energy market and the economy as a whole, though, may end up benefiting the economy. As the New York Times notes:
"If oil prices continue to fall, as many analysts now expect, that could relieve some pressure on the economy"


Amanda Cuellar said...

mmm... my link to the article didn't work as I wanted it to. Click the title of my entry for a link to the NYT article.

JR Ewing said...

Ms. Cuellar,
A few things I would like to point out. First of all, an increased price will not decrease demand, but quantity demanded. "Demand" is a curve, not a point on a graph.

Secondly, the Wall Street Journal article uses heating oil and gasoline as general examples of petroleum products. I don't think it means to infer that the quantity demanded for heating oil and gasoline will decrease relative to other types of petroleum products.

I think you were trying to get at the fact that different types of petroleum products have different elasticities. Elasticity is the change in quantity purchased of a product in respect to price change.

As far as oil prices effecting the economy, the high oil prices can cause what is known as stagflation. Stagflation is a combination of inflation and low/no economic growth. (economic growth can be measured in GDP or unemployment levels) The bad part about stagflation, is that it is difficult to get out of using traditional Keyensian economic stimulation tactics.

For example, if the government implements expansionary monetary policy during periods of stagflation, inflation will increase. If contractionary monetary policy is used, GDP growth will slow down further

There is no "quick answer" using different types of fiscal policy, as an increase in governement spending will cause further inflation and an increase in taxation causes a further slowdown in economic growth.

In response to the last statement in your entry "If oil prices continue to fall, as many analysts now expect, that could relieve some pressure on the economy", keep in mind that it is just as easy for the economy to affect the price of oil as the price of oil effecting the economy.

JR Ewing

Amanda Cuellar said...


Thanks for the comments on economic theory. Perhaps the New York Times should have used other examples for products whose demand will change with changing oil prices.

Also, the NYT article did note the effect of oil on the economy and of the economy on petroleum prices. It seems that the current economic situation, though, will favor a continued decrease in oil prices. I am not an economist or a fortune teller, but this is what I deduced from the information in the article.


hacfred said...

Before I say anything else about the subject let me make it clear – I’m not an economist and I don’t know much about economic theory however, what I would like to comment on is the gist of the article and the gist of what Amanda was saying.

I, like Amanda, appreciate the clarifications that JR made on the subject. I have heard about stagflation but never really understood it so this definitely helps. However, I think that bottom-line what Amanda was commenting on and what the article is trying to say is that the economy isn’t doing too well and that oil prices have started to drop and that this drop might actually be beneficial in that it can help us reverse this cycle (economic downturn). In my mind, the problem with using economic theory to explain oil prices is that oil prices don’t seem to follow any logic!

In his January 8 blog entry Dr. Webber commented about oil futures “I don’t understand oil futures” by citing two instances in which oil prices acted in an inconsistent manner (when Bhutto was assassinated oil prices jumped and when Iranian speedboats approached US Navy ships oil prices dropped). This, along with what happened the last couple of days, seems to indicate one thing: the Markets are in a state of fear and emotions are running the show, not economics!

On Friday the President announced his stimulus plan, the market didn’t really like it so the Dow closed down slightly. US markets were closed on Monday for the MLK holiday but Asian Markets fell an average of 5 to 7%. The same story was repeated in Asia today. The Dow opened about 500 points lower this morning before it reversed the cycle after the emergency Fed cut. In the meantime, oil prices started to drop and the logic is that a recession implies fewer jobs, perhaps lower income, less discretionary spending and who knows perhaps demand for oil will drop.

There is nothing to explain why the markets are reacting the way they are. What really happened on Friday or Monday to cause Asian and European Markets to drop as much as they did? I doubt economic theory can explain that and by the same token I doubt anyone can explain what oil prices are doing.

JR Ewing said...

It is much easier to explain the long term relationship (recession) between the economy and oil than the short term effects (Bhutto assasination, etc.)

Traders, which are prone to panic, are very active in the oil market, and can blow the effects of geopolitical events on the oil market out of proportion. It can often take time for the market to correct over or under adjustments.