Oil gained more than 20 percent in the first half of 2018, and odds have been rising that higher crude oil prices will spark the next economic downturn. This should not come as a surprise for any investor who is a student of market history: The last five U.S. recessions were also preceded by a rise in oil prices. In July 2008, even when the Federal Reserve was still betting that it had a handle on the economy, Warren Buffett warned that "exploding" inflation — whether in the price of oil or steel — was the biggest risk to the U.S. economy. “Quickly rising oil prices have been a contributing factor to every recession since World War II,” said Moody's chief economist Mark Zandi. Odds of a 2020 U.S. recession have risen to 34 percent, from 28 percent before this year’s spike in crude oil, Moody’s stated in a report.

Customers pump gasoline into their cars at a gas station in the Bronx, New York, where gas prices rose to over $3 per gallon in June. DON EMMERT | AFP | Getty Images

The math on how much higher oil prices hurt the economy

“If we do get oil prices of $100, $125 or $150, you reach a severe pain threshold, and not just for the U.S.” said Bernard Baumohl, chief economist of the Economic Outlook Group in Princeton, New Jersey. “There’s nothing vague or ambiguous about it. You reach a pain threshold in the triple digits, and there is a much higher probability of a global downturn. … It would be cataclysmic.’’ Baumohl isn't a believe in the recession theory, though. "You can have a statement made that drives [oil prices] up one day and down the next, the key is to focus on fundamentals," he said. Assuming no major geopolitical crisis, and that is a big assumption, we expect to see a downward slope even with Iran sanctions." The reason: U.S. shale output will continue to rise from what is already a record level. "By next year, the U.S. will be the largest producer of oil in the world," Baumohl said. U.S. West Texas Intermediate crude oil prices were around $68 on Monday, while Brent crude oil was near-$73. The issue of more expensive crude and its economic ripple effects boils down to two questions: What would happen if crude really went up above $100, and how likely is that scenario, really? The first question can be answered, at least partly, using some established rules of thumb about how much spending on gasoline cuts into other consumer spending. Baumohl cites an estimate that every penny added to the price of gasoline reduces consumer spending by $1 billion a year. Zandi estimates that every $10 added to crude prices would reduce U.S. growth by 10 to 15 basis points, or 0.1 to 0.15 percentage points, in the year after the increase. Going from $50 to $75, which has already happened, will reduce growth by a quarter of a point to nearly half of 1 percent, Zandi said. If oil hit $150, an economy recently growing near a 3 percent rate would see growth fall by half, and that’s before higher prices sparked inflation and forced interest rates higher, Baumohl said. “I think $150 oil in a short period would suck the wind out of the expansion,” Zandi said. “Recession risks would be very high.” Before the 2008 recession, the price of Brent crude, traded in Europe and used in most of the world, rose to about $140 in June of that year, a month before U.S. prices for regular gasoline topped out at an average of $4.11. Today gasoline costs on average about $2.87, according to the Department of Energy. Oil prices also spiked right before the 1990 downturn, running from $15 in May to $40 by September as Iraqi dictator Saddam Hussein invaded Kuwait. It then jumped from $10 as the dot-com boom gathered steam in late 1998 to nearly $30 by the time the Nasdaq average peaked in early 2000.

The harder question is whether oil really is likely to go anywhere near $150, or whether U.S. suppliers can head off the worst of the damage by increasing domestic production. Another significant factor is whether they can build pipelines fast enough to carry crude from newer “tight oil” fields in Texas — made newly pumpable by hydraulic fracking technology — before prices spike. The conventional wisdom since oil prices collapsed in 2014 has been that U.S. suppliers, who need a higher price to be profitable than many members of the Organization of Petroleum Exporting Countries, or OPEC, would ramp up production whenever crude topped about $50 a barrel. That has been upset by a shortage of pipelines serving Texas’ Permian Basin, home to much of America’s cheapest-to-produce crude oil, said Paul Tossetti, executive director of short-term crude market forecasting for IHS Markit. Both Tossetti and Rystad's Tonhaugen said the pipeline issue has nothing to do with delays in building the controversial Keystone XL pipeline, which will originate in Canada. Texas producers' inability to get their crude to market efficiently is forcing them to sell it on West Texas-based markets, whose benchmark price is about $15 lower than oil sold in Oklahoma and $18 below the Brent crude price. “It’s a $23- to $25-a-barrel difference [on some days], and that is a lot,’’ Tossetti said. The case for $150 oil is based on the fact that major oil companies slowed capital spending devoted to the search for new sources of supply to their lowest point in a generation, mostly outside of the U.S., when crude oil moved as low as $30 in 2016, Bernstein analysts led by Neil Beveridge wrote. Companies like ExxonMobil and Chevron curtailed capital spending to protect their share prices with stock buybacks and dividends, the report said, and that means a shortage of new supply.

The market is on a thin edge, where we could lose more supply than Saudi Arabia [and other swing producers, like Kuwait], are able to increase by in the next six months. That leaves oil-price risk skewed to the upside and vulnerable as global spare capacity will be put to the test. Bjornar Tonhaugen head of oil markets at Oslo-based Rystad Energy