ANALYSIS:Threatened by Middle East unrest, reduced fuel supply could have very serious implications
CAN SURGING oil prices imperil global economic recovery? That’s a question increasingly the focus of debate among market strategists. Continued instability in oil-producing states saw Brent crude hit $116 this week, an increase of over 20 per cent since January and well over double the levels recorded just two years ago.
The spike saw oil prices close more than three standard deviations above their 50-day moving average recently, something unseen since oil began its multiyear bull run in 1999.
Events in Libya, which has seen daily oil production plummet from 1.6 million barrels per day (bpd) to just a quarter of that figure, have exacerbated supply concerns.
While Libya has the largest oil reserves in Africa, it only produces 2 per cent of the world’s oil, making it the 17th-largest oil producer. That may sound insignificant, but the production curtailment ranks as the eighth-worst oil supply shock since 1950, according to Merrill Lynch research.
Not only that, but Libya’s sweet light oil is top-quality and highly prized in world markets. Saudi Arabia, which claims to have increased production by over 500,000 bpd, produces more sulphurous medium crude oil.
“The concept of a barrel for barrel replacement is not a correct one,” noted a Barclays Capital analyst last month.
And it’s not just Libya. There has also been well-publicised unrest in Yemen, Bahrain, Oman and Syria. None of these countries match Libya for oil production, with Yemen (260,000 bpd) and Bahrain (just 45,000 bpd) mere minnows on the world stage. Nevertheless, escalating instability in Bahrain resulted in the Saudi stock market recently tanking by 15 per cent in a single week.
The majority of Saudi oil is produced near the Bahrain border, and social discontent in Saudi Arabia itself is on the rise. There is also the question of increased tension between Saudi and Iran, which are supporting rival groups in Bahrain. Saudi, the second-largest oil producer globally behind Russia, produces 12 per cent of the world’s oil, with Iran contributing a further 5 per cent.
According to Citigroup analysts, 3.3 million bpd of oil supply is at risk, although they “don’t completely discount the risk of more significant volumes being affected”.
In theory, any supply shortage should be manageable. Saudi Arabia, for example, claims to have 3.5 million bpd of spare capacity, meaning total Opec spare capacity should be above five million barrels per day. Not everyone believes these figures, however. Commodities guru and oil bull Jim Rogers has repeatedly laughed off such claims, asserting the Saudis’ oil reserves are not nearly so substantial, while Goldman Sachs analysts believe that, since November, the Saudis have been producing up to one million bpd more than official figures suggest. Goldman warns that Opec spare capacity “could actually have dropped below two million bpd already”.
Other commentators note that while Saudi Arabia has traditionally upped production to curtail excessively high prices, it was much slower to do so during the most recent oil crisis. Saudi oil production actually declined between 2005 and 2007, according to Californian economics professor and blogger James Hamilton.
Although increased in 2008, when oil prices topped out at $147, production levels were merely brought back to 2005 levels.
Analysts at Barclays Capital are also sceptical, warning that key oil producers “could well be somewhat on the slow side in terms of acting to rein in the upside, with ultimate control re-established at higher price levels than $100”. They have a $135 price target for Brent.
What impact might this have on the global economy and corporate earnings? According to JP Morgan, each $10 oil price rise typically impacts earnings by 1 per cent. Fatih Birol, chief economist at the International Energy Agency, estimates that an oil price averaging $100 in 2011 would cost the US an additional $80 billion in oil imports, with the EU paying an additional $76 billion.
For the EU, this would be a bigger increase than that seen in 2008, when oil hit bubble levels.
Analysts agree that a brief spike should cause little economic damage. A sustained period above $110 in 2011, however, would likely engender demand destruction, Merrill Lynch warns, and a “spike-and-crash scenario” becomes likely in the event of further increases in oil consumption and a severe supply shock.
Other analysts’ estimates appear more sanguine, with many calculating a $20 oil price increase would reduce US gross domestic product by approximately 0.5 per cent. However, increased gasoline prices can have a disproportionate impact on consumer confidence, which recently fell to its lowest level in six months.
As to the question of oil demand, everyone is looking east. The Chinese are using 9.5 million bpd, 10 per cent more than a year ago. Having accounted for 40 per cent of the increase in global oil consumption between 2004 and 2009, China is now second only to the US in terms of oil consumption.
Unsurprisingly, it is concerned about oil’s inflationary potential. Inflation in China is running at 5 per cent, double last year’s figure.
On the other hand, there has been demand destruction in Japan. The economic slowdown engendered by the recent tsunami is estimated to reduce demand by approximately one million bpd, almost cancelling out the Libyan supply shock. The rebuilding effort there in the wake of the earthquake and tsunami is expected to see demand increase, while the global move away from nuclear power is also seen as bullish for oil.
Nevertheless, the Japanese economic shock means that “on a pure supply/demand basis, oil prices should go down $10 or $15 a barrel,” according to Allen Sinai, an economist at Primark Decision Economics.
Oil prices can move on perception as much as on a supply/demand basis, however. Past oil supply shocks have seen actual output fall less than initially expected, as producer countries increased production to compensate, but the oil price spikes nevertheless led to market falls and recessions. The speculative bubble in oil prices seen in 2008 did not burst until July of that year, a full seven months after the US went into recession.
The Libyan crisis has already resulted in hedge funds making a record number of bullish oil bets.
There is also the point, made by Ben Bernanke in an academic paper in 1997, that the majority of an oil price shock on the real economy is “attributable to the central bank’s response, not inflationary pressures engendered by the shock”. Already, the European Central Bank has signalled that it is likely to raise interest rates next month, concerned as it is by inflationary pressures.
Since the second World War, geopolitical events have led to six oil supply shocks. The first five led to recessions, but the last, the Venezuelan strikes at the end of 2002 which were quickly followed by the Iraq war, did not.
At that time, there was a 4 per cent loss in global oil output, significantly larger than Libya’s figure of 2 per cent. The Libyan figure is only one-third the size of the smallest of the first five disruptions, Prof Hamilton notes (output losses were in the region of 7-10 per cent in the other cases).
Clearly, a quick resolution in Libya, coupled with a diminution in tensions elsewhere, should see oil prices fall back. An escalation in Middle East unrest, however, and the threat of a more serious disruption in supplies, risks the type of “spike-and-crash” that is increasingly concerning analysts.
