Is oil the new Greece? That’s the question currently being asked by many market analysts.
One could be forgiven for thinking that after so much unease surrounding the economic consequences of a Greek failure there may be a sense of elation or at least relief that an apparent crisis had been averted.
On the contrary, even before confirmation of a 206billion euros debt exchange had been announced, investors’ thoughts had already moved on to the next possible shock for the global economy.
Such concerns are understandable, Brent crude prices hit a 43-month high in early March following subsequently denied reports that a key pipeline had exploded in Saudi Arabia. Although the North Sea benchmark price has since eased back to around $125; this is still significantly above the low of $75 seen in October.
So what are the immediate risks presented by rising oil prices, what are the potential economic consequences and how is this likely to feed through to equity markets?
Firstly, investors need to consider the factors influencing recent oil price movements. Certainly from a demand perspective the picture doesn’t look great. Europe is currently in recession; the UK economy is flat-lining and while the recovery in America appears to be gathering pace there is still a sense of fragility. Admittedly, this has been offset by increasing appetite from emerging markets, even so in its most recent monthly report OPEC noted that it expects world oil demand to grow only marginally this year.
With demand by and large unchanged, a frequent argument put forward for the oil price rise is Central Bank largesse. In the midst of a recessionary back drop, Central Banks of developed nations, including the Federal Reserve and Bank of England, embarked on an array of loose monetary policy measures with quantitative easing (QE) one of the key tools.
Although a direct link is contentious, what cannot be ignored is the impact QE has played in weakening sterling. When oil hit a US dollar record of $147 in mid-2008, the pound was worth around $2, equating to roughly £72 per barrel. At the time of writing, that same pound buys just under $1.57. As a result, the current price of around $125 converts to just shy of £80, an all time high.
Political risk coupled with short-term supply shocks has also had a major influence. Iranian sanctions, a pipeline dispute in South Sudan and recent supply disruptions in the North Sea, Syria and Yemen have taken their toll.
Of course, tensions with Iran dominate headlines and in particular the ongoing threat of conflict. The undoubted fear would be that Iran act on its threat to close the Strait of Hormuz which some 17million barrels of oil, or 20% of global supply, flow through every day.
Globally, the impact of oil price rises on growth and inflation in individual regions and countries will vary. In the developed world, sustainable growth is the primary concern.
Domestically, the Bank of England has been steadfast in its view that inflation will gradually ease as the year progresses. A rising oil price most definitely has the potential to derail such a forecast.
In an environment of constrained wage growth, demand would likely slump and undermine any economic recovery. Such a scenario presents a major headache for the Bank of England and Federal Reserve.
As growth slows, QE would likely once again be the policy tool of choice in kick-starting the economy. As has happened with previous bouts of QE, excess liquidity, in the search for yield, will trickle overseas, potentially fuelling further oil demand and thus pushing prices higher. A vicious cycle then ensues. High oil prices erode any prospect of recovery which then forces policy makers to persevere with ultra-loose monetary policy to foster growth, thereby perpetuating the cycle.
Inflation, rather than growth is of more pressing concern for emerging economies. In an attempt to counteract this we saw some very aggressive monetary policy tightening. Softening demand and slower growth is now the result, perhaps most notably in China.
Interestingly, an oil price rise does not uniformly lead to lower equity market returns. Equity market response has historically depended on whether price increases have been demand-driven or supply-driven. A demand-driven increase would tend to indicate robust economic growth with equity markets holding up well as a consequence. Sharp, unanticipated supply-related shocks, however, such as Iraq’s invasion of Kuwait in 1990, have strongly negative implications.
A blockade of the Strait of Hormuz would without doubt fall into such a bracket, and should tensions escalate in this direction we may well see a further sentiment led sell-off in global equity markets as the “risk-on” trade flips back over to “risk-off”.
Stuart Lamont is investment manage at the Aberdeen office of wealth management specialist Brewin Dolphin.
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