|Fig. 1: Oil price history in nominal dollars. |
One fundamental idea in economics is that a single value, namely price, can be used to synthesize all aspects contributing to the relative desirability of an object, thereby allowing us to compare the value of different things. When there is drought and crops fail, the price of food goes up until the number of buyers matches the number of sellers. The price of oil also changes thusly. Since the turn of century citizens of the United States have become progressively more dependent on oil to maintain its high standard of living, to the point that it now takes over 18 million barrels of oil per day to keep the U.S. economy going.  Transportation of people and goods, industrial processes, and even just keeping the lights on all rely on the availability of large quantities of cheap oil. But the question remains, how exactly does the price of oil link to the economy as a whole?
The earliest attempts to link oil price to the economy assumed that that increased oil prices would decrease demand for products that use oil intensively, such as automobiles, thereby impeding economic growth.  More recent theories, however, suggest supply-side effects dominate the link between oil and the larger economy.  During a period of price increases, the increased production costs and reduced availability of oil tends to limit the potential output of an economy, thereby also limiting growth potential. Ultimately this effect lowers the gross domestic product (GDP), which is a primary metric for monitoring the health of the economy. Increasing inflation also tends to follow sharp oil price increases due to the altering of the supply-demand balance, although this effect seems to have diminished after 1981.  Others have suggested that the primary detrimental effects of oil price increases derive from poor monetary policy in an attempt to curb inflation induced by oil price shocks.  Increased oil costs have also been negatively correlated with employment and wages.  Regardless of the interpretation of the oil-macroeconomic link as demand or supply driven, these effects tend to rein in economic growth. However, supply-side effects also help to explain why extra economic growth is not observed during periods of declining oil prices.
Up to now, only the effects of price increases on the economy have been discussed. Fig. 1, which displays historical oil prices in nominal dollars, shows that there have also been many periods of decreasing oil price. If the relationship between oil and the aggregate U.S. economy were log-linear as in the demand-side interpretation, we would expect the above consequences of oil price increases to be reversed in the case of oil-price decreases. For example reduced oil prices would lower production costs and increase GDP. However, empirical evidence suggests the relationship between oil and the U.S. economy is asymmetric.  Sharp rises in oil prices tend to retard the economy more than declining oil prices spur economic growth.
One possible explanation for such asymmetry is that while declining oil prices may encourage economic growth, supply-side frictional losses associated with optimizing production to new oil prices counteracts gains that could be made by the price decreases themselves.  For example, decreasing oil prices may require an automobile plant to retool to assemble compact conventional fuel cars instead of hybrid vehicles. Although falling oil prices may increase the sales of automobiles on the demand-side, these gains could easily be wiped out by the production costs of retooling the assembly line. Another possibility is that uncertainty and financial stress introduced by changing prices tends to amplify negative effects of price increases and nullify some positive effects of price decreases.  In reality, it is likely a combination of these effects and others are to blame for the asymmetric response of the economy to oil prices.
Another important component to the overall health of an economy is the state of equity markets. A strong stock market encourages optimism and further investment. The exact effects of oil price on stock market performance are controversial, however several studies have shown a statistically significant correlations.  There are several complications in linking oil and stock price behavior. Primary among them is that the cause of an oil shock tends to be a principal driver for the degree of impact on equity markets. Oil price increases due to precautionary demand and uncertainty tend to reduce stock prices. Production disruptions tend to have very little effect on stock prices even though oil prices are driven higher through limited supply. Conversely, price rises due to demand driven by economic expansion tend to correspond with stock price increases. It has been shown that through these effects oil supply shocks account for over 20% of long-run variation in U.S. stock returns. 
As oil becomes more in demand and eventually more scarce, understanding the complex relationships between oil prices and the rest of the economy will become even more important. Shocks may become more prevalent, and the best chance we have to control their impact is to generate a more complete understanding of the possible ramifications on society.
© Ian Schultz. The author grants permission to copy, distribute and display this work in unaltered form, with attribution to the author, for noncommercial purposes only. All other rights, including commercial rights, are reserved to the author.
 A. Rascoe, "U.S. Oil Demand Dipped to Near 4-year Low in July," Reuters, 17 Aug 12.
 J. D. Hamilton, "What Is an Oil Shock?," J. Econometrics 113, 263 (2003).
 F. Lescaroux and V. Mignon, "On the Influence of Oil Prices on Economic Activity and Other Macroeconomic and Financial Variables," OPEC Energy Review 32, 343 (2008).
 M. A. Hooker, "Are Oil Shocks Inflationary? Asymmetric and Nonlinear Specifications Versus Changes in Regime," J. Money, Credit, and Banking 34, No. 2, 540 (2002).
 B. S. Bernanke, M. Gertler and M. Watson, "Systematic Monetary Policy and the Effects of Oil Price Shocks," Brookings Papers on Economic Activity, No. 1, 91 (1997).
 N. S. Balke, S. P. A. Brown and M. K. Yucel, "Oil Price Shocks and the U.S. Economy: Where Does the Asymmetry Originate?," Energy J. 23, No. 3, 27 (2002).
 J. D. Hamilton, "Causes and Consequences of the Oil Shock of 2007-08," National Bureau of Economic Research, Working Paper No. 15002, May 2009.
 J. P. Ferderer, "Oil Price Volatility and the Macroeconomy," J. Macroeconomics 18, 1 (1996).
 L. Kilian and C. Park, "The Impact of Oil Price Shocks on the U.S. Stock Market," Int. Economic Review 50, 1267 (2009).
 "BP Statistical Review of World Energy 2010," British Petroleum, June 2010.