[MUSIC] Hi there. In this set of two videos, we're going to have a look at the second example of a real crisis. We're going to be talking about oil prices and oil shocks. We're going to have a look at what impact the oil price may have on the stock market and we're going to see that it depends a lot whether it's supply or demand driven. Now, let's take a look at the first oil shock, what is known as the first oil shock, and this goes back to 1973. At that time, the Arab members of OPEC decided to go on an oil embargo. Basically, they took the decision that at $4, the oil price was way too low. And what they did is they did an embargo. So no more oil was going through the pipelines, and this lasted until March, 1974. By that time, the oil price had quadrupled from $4 to $16. Today, it's much more than that and it has been going way above the $16. But just imagine, in just six month the oil price goes from $4 to $16. That's a shock I can tell you. So economists and academic research, when they have to analyze what impact the oil market and the oil price is going to have on the stock market, basically we have to find out whether it's an increase in the oil price is due to a restriction of supply, like here the embargo in 1973, or whether the increase in oil prices Is due to a booming demand. And we'll see that the implication for the stock markets are completely different. Basically, if the increase in the oil price is due to a supply constraint, this is an exogenous shock. Whereas if the increase in the oil prices is due to a booming demand, this is an endogenous increase in the oil price. And it has very different implication for the stock market. Let's illustrate this with the following chart, which depicts here in red and on an inverted scale, you know how I like inverted scales. [LAUGH] So here you have one. You see the red line. So when it's dropping, it's actually an increase in the oil price. Why do I do this? Because I want to see whether this increase in the oil price that we see for instance in 1973, as we just saw. When the oil prices increases by a peak of 170%, you see that on the left hand scale, and you see that it coincides, we have a recession. That's the blue bars and they're pointing south. They're pointing downwards, and this is US GDP, so negative growth recession. So typically, oil shock, supply constraint, recession. Why? Because basically, when the oil prices goes from four to 16, basically, the purchasing power of the consumer and we know that this is the driving force of the US economy, it was then, it still is today, they get hit, badly hit. And so, you have less money to spend for other items, more money that you need to spend for oil and energy. So you trigger a recession. So what I have identified here is that whenever the oil prices increase by more than 30%, we see each time that the oil price has risen over history by more than 30%, generally this has been followed by as either a sharp slow down of economic activity, we're talking about U.S. but we can see this on a more larger scale in the rest of the world and this is also true. It's either a sharp slow down or a recession. Possible exception, we'll see that in a minute, is the example where, again, the increase in the oil price does not reflect a decision by the producer countries to restrain supply, but it's due to maybe a new actor coming into the economy and a booming economy, so increase in the demand for oil. And here we think of China, and we'll see that in a minute. Equivalently, an increase of the oil price here, I do the same as with the previous chart, but I put the oil prices in real terms. Economists like to analyze the oil price in real terms. So it's basically the evolution of the oil price, as compared to the Consumer Price Index, what we call the core inflation rate. So it's the Consumer Price Index. Less food and energy, because they don't have to have energy and compare it to an index which also has energy. And here we see that whenever this real oil price increases by more than 20%, it coincides soon after or immediately after with either a sharp slow down or a recession. So then the key question you should ask you self whenever you see an increase in the oil price is that what is the central bank going to do with this. Does it think that this is going to be a shock on inflation and hence it's going to raise interest rates, and then trigger possibly a recession? So this is one mistake which was done in the 70s. Central banks at that time were over worried, were worrying too much about inflation, and they were not making enough of a difference between demand pull inflation and cost push inflation. When you have a constraint on oil production and the oil prices go through the roof, inflation may rise, but it will trigger a recession, as we just saw. And if on top of that the Central Bank raises interest rates, then you're throwing oil on the fire. And this will exacerbate the recession even further. So in conclusion of this first video, we need to assess when we experience an increase in the oil price, whether it's going to be a problem more for inflation, or for the economy, or possibly both. As we see from this chart, you see these purple bars, the vertical bars, they indicate a recession in the US. And we see the evolution of the oil price in red, and this is in real terms, and in blue, it's the inflation. And you'd see that at sometimes you have a sharp increase in inflation. And concomitant to that, at the same time, we have a recession. So this we call stagflation. So again here, it's very important to know we have an increase in the oil price. If it's due to a constraint on supply or supply is restricted, then it's a mistake for a central bank to go in this environment and raise interest rates, because you will be throwing oil on fire. You have already the increase in oil price, which is going to slow down the economy and lead it possibly into recession. And if on top of that, a central bank hikes interest rates, because it sees inflation, you have more chances of the economy going into recession. So in the next video, we'll see how an increase in the oil price can actually be seen as a positive, both for the equity market and the economy. [MUSIC]
