Although we are now in a two-week ceasefire, the situation remains unresolved. We are still in an oil shock. Historically, oil shocks have preceded recessions: the 1973 OPEC oil embargo led to a severe downturn, the early 1980s double-dip recession was triggered by an oil shock, the 1991 recession followed a similar pattern, and even the 2008 financial crisis came after a substantial rise in oil prices. However, it was not the oil shocks themselves that directly caused these recessions; rather, it was the central banks' responses — tightening monetary policy to counteract the inflationary effects of supply disruptions — that caused/triggered those economic downturns.
Today, central banks' responses will depend on the severity of the shock, which is a function of four factors: the state of the oil market at the onset of the crisis, the health of the economy, the magnitude of the shock, and its duration. This crisis found the energy market in a relatively balanced position, which is helping to ease some of the impact. Nevertheless, both the U.S. and Canadian economies were already exhibiting signs of weakness prior to the crisis. The more than 50% increase in oil prices since late February is substantial by any measure. The duration of this shock remains uncertain, but even if the conflict were to end tomorrow — which is unlikely — it would take weeks or months for oil flows to normalize and much longer for the natural gas market to return to equilibrium. By all accounts, we are in the midst of a significant oil shock.
There are numerous rules of thumb for estimating the effects of higher oil prices on economic growth and inflation (such as a X% rise in oil prices leading to Y% decrease in GDP growth and Z% increase in inflation). We view these rules with skepticism, as the four key factors outlined above have varied considerably across previous shocks. Additionally, the Canadian energy sector is now smaller than in past episodes, while the U.S. energy sector has expanded.
Another important consideration is the "green" push of the past two decades, which has led to notable improvements in energy efficiency. In theory, this should provide greater resilience against oil shocks. However, the reality is more complex. Energy efficiency is not the ultimate goal — reducing total energy consumption is. Despite substantial gains in efficiency, overall energy usage has not declined as much as expected. While energy use per unit of U.S. GDP has dropped by over 30% in the past twenty years, total energy consumption has not decreased, and per capita energy use has only fallen at half the pace of efficiency improvements. This is the efficiency paradox also known as the Jevons effect: as energy efficiency improves and the effective cost of energy falls, substitution and income effects might lead to increased consumption.
The transportation sector, which accounts for nearly 30% of end-use energy consumption in the U.S., is a good example of the paradox. Over the past 15 years, fuel economy for cars and trucks has improved by about 10%-15%, and for airplanes by nearly 20% — thanks to technological advancements and stricter standards. Yet, total energy consumption in transportation has scarcely changed, largely because Americans continue to favor larger vehicles, vehicle miles traveled have increased, and air travel has grown steadily, offsetting the gains from efficiency.
The same goes for the residential sector that is responsible for roughly 20% of end-use energy consumption. In the past 15 years, furnaces, air conditioning units, washers, and refrigerators have all become markedly more efficient (with refrigerators now 20% more efficient). Still, overall household energy consumption has changed little, as larger homes and more/larger appliances have offset the efficiency gains.
The bottom line: beware of simplistic rules of thumb — not all oil shocks are created equal. Policymakers and consumers alike should not expect the energy efficiency gains of recent decades to shield them from the current oil shock. The efficiency paradox means that, efficiently, Americans continue to consume plenty of energy.