Oil prices (Brent) are up 14% since the beginning of the year. How bad is this, and how bad can it get? The consensus so far is that this is mostly a demand-driven move rather than a supply shock: after the gloom of Q4, data and news flow have been encouraging, with better than expected activity figures in the US, progress on the Eurozone-crisis front, and resilience in China’s economy. The rise in oil prices has been led and accompanied by a 16% surge in stock prices since late-November (S&P500). And the mini-correction of the last couple of days has preserved the correlation: equities inched down 2.2% and oil prices lost 3%. If oil prices had been driven up by a supply shock, or fears of a supply shock, this should be reflected in a more pessimistic growth outlook and a weaker performance of equities. A demand-driven price move is more benign, so in principle the oil price rise should act as a gentle brake on the global recovery and be still consistent with an outlook of moderate but resilient growth.
Figure 1. Oil and equities
There is a disturbing feeling of déjà vu, however. At the beginning of last year we also saw a sharp demand-driven rise in oil prices, but the accompanying greater optimism on global growth was soon replaced by dismay as the recovery lost momentum. Are we in for the same disappointment?
Last year’s price rise was sharper. Over the same period Brent prices climbed 22% compared to this year’s 14%. But last year we had started from a lower level, whereas today, at about $125pb Brent, we are already at the peak reached in April 2011. The only time we have seen higher levels was in the 2008 oil price spike that preceded the Great Recession.
Figure 2. Brent oil price as of 6 March
While prices are now higher, last year’s oil price rise was compounded by two additional shocks, the tsunami in Japan and a sudden worsening of the Eurozone crisis – so an oil price rise alone should not have the same adverse impact on growth. Moreover, this year food price dynamics have been much more subdued, whereas last year they exacerbated the rise in fuel prices pushing inflation rates up and eroding consumer purchasing power, especially in emerging markets.
Overall therefore, the rise in oil prices so far does not pose an excessive threat to growth. There are three caveats, however.
- First, equities and oil prices have something else in common besides the correlation with global growth. They are both higher-yield assets in a world of yield-free risk-free assets and ample liquidity (the ECB’s balance sheet just breached the €3 trillion mark, 60% higher than last spring). Global liquidity is probably amplifying fluctuations in the prices of risky assets. That implies a greater risk of oil prices running ahead off supply/demand fundamentals, with adverse effects on global growth.
- Second, a further sustained rise in oil prices, even if demand-driven, would take us into uncharted territory. We have never before seen a period of ‘normal’ global growth with oil prices in excess of $120 a barrel, and it is hard to say with full confidence that it would be sustainable.
- Third, if the price increase so far is mostly demand-driven, then by definition we are fully exposed to the impact of a supply shock, which would hit us when oil prices are already very high. Given the tensions surrounding Iran’s nuclear programme, this is not good news. Spare capacity in oil is limited, and inadequate to offset a sudden disruption of shipments transiting through the Strait of Hormuz. Oil prices would jump well above $150 a barrel (Brent); if they stayed at those levels for a prolonged period they could lower global growth by about one percentage point.
Additional consequences of a geopolitical oil shock would include a spike in risk aversion, with capital flowing out of risky assets and many emerging markets. Luckily, as risk appetite has only just improved over the last couple of months, emerging markets have not yet had time to accumulate very large hot money inflows, and this should limit the magnitude of the potential correction. Prices of non-energy commodities should drop on global growth concerns, and traditional safe haven currencies including the yen, Swiss franc and US dollar should strengthen.
Winners and losers
It is fair to ask whether there would be any winners in such a scenario. Middle East oil producers would get a higher price per barrel, but would be exporting fewer barrels and would suffer from the further escalation of tensions in the region. Other oil producers, including Russia and Venezuela, would benefit the most. China should be shielded by its considerable scope for policy stimulus, and Brazil by its relatively stronger energy fundamentals.
Advanced economies have achieved a greater degree of energy efficiency than emerging markets, but they have no room left for policy stimulus, the US recovery is still fragile, and Europe is facing a potential credit crunch. The US would enjoy a limited cushion from the lower natural gas prices, given the limited substitutability of oil and gas in the short term. An oil shock would push Europe into a deeper and more protracted recession than what is now in the cards (and rising inflation would make for even livelier discussions at the European Central Bank…), while the US would decelerate again, halting the recent labour market improvement.
Some of the most vulnerable emerging markets would include Turkey and India. Turkey’s growth is already slowing significantly as a consequence of its large current-account deficit, which would be made worse by even higher oil prices. India has substantial subsidies on domestic fuels prices, so that a further spike in international prices would force it to choose between a wider budget deficit (if it maintains domestic fuel prices close to current levels) and a higher inflation rate (if it raises domestic prices rather than giving a higher subsidy). Both options are unpalatable. Small open economies such as Korea and Thailand would suffer from the decline in global growth and trade.
The findings of this research – along with the questions raised – can be summarised as follows:
- Global growth looks stronger, and crude oil prices eagerly climb to new highs – up 14% year to date. Same as a year ago. Are we in for the same disappointment? The positive correlation with equities suggests oil prices are driven higher by stronger economic growth, so they should act as a gentle brake on the recovery rather than as a brick wall.
- Prices are already at record high levels, however, with the sole exception of the 2008 pre-Lehman spike; we could soon enter uncharted territory. And in a world of yield-free risk-free assets, global liquidity might push oil prices (and equities) ahead of fundamentals, imperilling the recovery. Not to mention Iran: if prices so far reflect only fundamentals, the full brunt of any shock still lies ahead.
- If a true oil shock comes, the list of casualties will have Europe at the top, the US, emerging markets with large current-account deficits or generous fuel subsidies, like Turkey and India, and small open exporting countries as global trade slows sharply. The (shorter) list of winners would include non-Middle East oil exporters and the economic doomsayers. And we might all start believing that the current recovery was born under an unlucky star.