Dollar and Oil: Déjà vu?
Huge price swings in both the U.S. dollar and oil prices have led many analysts to look for historical references. The mid-1990s could be a good starting point since the dollar rose while oil prices fell. The U.S. economy was in mid-cycle and the Fed was ahead in its tightening cycle while the Mexican crisis of 1994 highlighted the sensitivity of emerging countries to U.S. long term yields (seen as a proxy of global liquidity).
By many aspects, the mid-1980 also look like a good candidate… until the U.S. dollar is taken into account. The reasons why today’s situation may look like the mid-1980s are plentiful:
1. In the years that led to the 1986 price collapse:
a. Saudi Arabia artificially limited – but could not impede - the fall in oil prices, cutting its production by almost three quarters between 1981 and 1985 (from 10 to 3 mb/d when global oil production only edged up by 1Mb/d). In 1986, after several years of unsuccessful attempts to force OPEC partners to observe their production quotas, the Kingdom decided to increase production sharply, abandoning the policy carried out since 1981 to bring oil production back to 7mb/d in 1990. This retaliation against the cartel’s “free riders” triggered what is generally called the “reverse oil shock”.
b. Meanwhile, long lasting high oil prices had led to:
An increase in supply: the exploitation of Alaska and North Sea Oil fields (they were discovered in the 60s but extraction was too costly up to the mid-70s) as well as those of the Gulf of Mexico was made feasible thanks to the OPEC policy. When Saudi Arabia changed its policy, this led to a long lasting supply glut.
Oil-saving measures that led to a fall in demand in many developed economies: between 1975 and 1985, the energy consumption per real dollar of GDP fell from 13.58% to 10.06% (it only edged down to 9.43% in the five years that followed, as lower oil prices reduced the incentive to save energy).
- Lastly, the shock dealt a blow on many U.S. producing states with a sharp decline in local job markets. The chart below, drawn from a 2009 paper, shows that those states entered a recession independently from the rest of the nation (ex post probability of being in recession for states members of the “cluster). There was no spillover on the rest of the economy.