With a stronger economic backdrop, demand for most goods will pick up, including for oil and money

Last year’s drop in economic activity was not just about a shortage of liquidity. The largest rise yet in global commodity prices and the most pronounced credit collapse in history occurred in the same quarter, in that precise order, for a reason. During the previous decade, capital investment failed to go into commodities to facilitate productive capacity expansion and went instead into other sectors such as property. In our view, the world was just growing too fast, given the constrained global resource base, and something had to give.

Simply put, limited quantities of energy, grains and metals just could not sustain strong global gross domestic product growth for ever. The rise in energy prices in the third quarter of 2008 and subsequent collapse in credit markets ultimately forced world economic growth into negative territory, pushing down industrial activity and driving up unemployment. Central banks then rushed to avoid deflationary pressures by producing as much money as they saw fit.

The divergence between oil and money has never been so apparent. For decades, the expansion of global oil consumption closely followed the expansion in global economic activity and global money supply. This relationship between the economy, oil and money started to change in 2005, owing to serious physical oil supply bottlenecks. Unlike oil, the supply of money and credit grew unconstrained from 2005 to 2008 as the global economy expanded, pushing up asset values worldwide. In their effort to bring the good times back, most central bankers have conveniently chosen to ignore the second-round effects of exceptionally loose monetary policy.

With a stronger economic backdrop, demand for most goods will pick up, including for oil and money. As oil demand starts to increase again, so will prices. Looking only at the narrowest definition of money for the top oil consumers, we estimate that one percent increase in money supply translates into a 1 per cent increase in oil demand four quarters later. We also calculate that narrow money supply growth increased from 5.8 per cent in August last year to 11.4 per cent in May, the most recent data point. More worryingly, many of the countries now experiencing large monetary expansions have a large share of their population in the $5,000 to $20,000 per capita income band, a sweet spot for energy demand. With that in mind, the Organization of the Petroleum Exporting countries’ effective spare crude oil productive capacity of 4.5m barrels a day or 5.3 per cent of global demand does not sound like much.

Higher prices could, of course, temper the forthcoming surge in global energy demand. Just as oil prices were an underappreciated cause of the global recession, we believe the oil price collapse has been an under- appreciated source of stimulus. If oil prices go up, the choice for central banks will be to throw OECD economies back into recession or to let headline inflation trend higher.

For consumers in the developed world, there is nowhere to hide. Governments in OECD economies have pushed credit problems into the next decade by nationalizing bank debt, but higher oil prices are likely negatively to impact on terms of trade and partially offset the positive impact of lower imports on GDP growth. Moreover, higher oil prices will act as an important drain on disposable income for most of the developed world.