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Chief Investment Strategist
A cursory examination of economic history might lead one to believe spiking oil prices always cause recessions. The popular press might lead you to conclude that current tensions with Iran have led to a speculative spike in oil prices, raising this risk of recession. However, it is our view that the primary cause of the current high price of oil is global supply and demand and that high oil prices by themselves do not mean an economy will head into recession. Demand-driven price increases are less problematic than supply-driven ones, as overall economic strength can carry the day. At the margin, the supply uncertainties tied to governmental changes in Tunisia, Egypt and Libya have likely added to pricing pressures. Additionally, the global sanctions and pending EU embargo on Iranian oil, along with the chance of armed conflict has raised the risk premium. It is also critical to understand the reaction of central bankers to the price spikes and the inflationary trends in other commodities. Today, we have global central banks committed to accommodative monetary policy and commodity prices outside of energy showing lower inflation. Todays price levels for global oil do not represent a clear and present danger to the global economy, however the risk lies in the potential of a future price spike caused by a Middle Eastern supply shock.
EXHIBIT 1: LITTLE CUSHION
Source: Energy Information Administration, Northern Trust Global Investments; data through 2011, est. through 2013.
Exhibit 1 illustrates the growing global demand for oil and the limited spare capacity available. Oil consumption increased by 27% from 1994 to 2011, including a 76% increase in non-OECD consumption. According to the Energy Information Administration (EIA) this upward trend is expected to continue, with global consumption projected to grow another 3% percent over the next two years. Further, excess capacity the difference in potential production from actual production has shrunk from 4.5 million barrels per day in 2000 to just over 2.5 million barrels. However, it is expected to rebound to 3.6 million barrels by the end of 2013. Before being too comforted by this, we need to incorporate the significant increase in usage over this time. In 2000, the spare capacity represented 4% of demand while in 2010 it was 3%, and has been much smaller at times over the last decade. In addition, the required capital expenditures to bring on increased capacity continue to rise (global exploration and production expenditures have risen over five-fold over the last 25 years), representing a further underpinning to oil prices. We think this continuing growth in demand, alongside ever more expensive supply, means high oil prices are here to stay (outside of recession-driven declines).
To assess the vulnerability of the global oil supply to a short-term supply disruption, we examined the worlds 20 largest oil producers in Exhibit 2. We categorized the counties into those we believe to have stable production outlooks and those countries where production could be at risk. In all, the top 20 producers are responsible for nearly 85% of the worlds oil. Of that, we consider over 35% to be potentially at risk with around 16 million barrels per day (b/d) of the worlds oil potentially impacted by a disruption of the Strait of Hormuz shipping lane. If the Strait were to be closed by military action or other developments, we believe that roughly 13.4 million b/d could be exported by on-shore pipelines after a two to four week period. But the pipelines could still be vulnerable to terrorism, and the oil unable to be exported would approximate 2.6 million b/d. This would be the effective equivalent of the UAE, Venezuela, Kuwait, Iraq or Nigeria ceasing production and cause a shock to prices. World oil reserves would likely be released, and could provide some salve for the short-term disruption. We view current discussions around the release of these reserves as being politically motivated and unlikely to meaningfully reduce prices.
EXHIBIT 2: TOO MUCH SUPPLY AT RISK
Source: BP, NTGI; 2010 data.
The countries that we categorize as having production that is potentially at risk have widely different circumstances, as follows:
- Saudi Arabia:While generally viewed as a steady producer, there are concerns regarding succession in the royal family; the expectation that a significant amount of Strait-bound oil could be exported via existing onshore pipelines mitigates some disruption risk.
- Iran:Beyond the clear risk of outright war, concerns regarding potential Iran-directed sabotage of Iraq, Kuwait and Saudi oil production facilities carried out by Shiite allies are also prevalent.
- Iraq:Possible civil war if main factions cannot come to power-sharing agreement.
- Venezuela:Resource rich but economically poor and has seen production decline over the past decade. Additional concerns surrounding the health of President Chavez and the risk of revolution in the event of his passing.
- Nigeria:Another example of a resource rich but economically poor country where the risk of civil unrest is an ongoing concern; heightened tensions between Christians and Muslims contribute to the possibility for unrest.
- Libya: Production climbing since the end of the revolution, but risk remains over in-fighting regarding oil revenue distribution in the absence of a credible central government.
The biggest oil shocks of the last 50 years were supply-related problems emanating from the Middle East, including the 1973 OPEC Oil Embargo and the 1979 Iranian Revolution. Demand-side related price shocks, such as the emerging market boom in the late 2000s, are much more infrequent. Looking at Exhibit 3, one could conclude that all the recessions since 1970 were preceded by a spike in oil, but whether the oil price spike was the cause or a coincident factor is worth additional research.
EXHIBIT 3: HIGH OIL PRICES PRECEDE RECESSIONS
Source: Bloomberg, National Bureau of Economic Research, NTGI; *real price of oil indexed to current price.
Taking a closer look, we examined economic growth in the U.S. and Europe following an oil price shock. We defined an oil price shock to be an increase of at least 40% in the price of oil over a six month period. This is in-line with the recent experience, where oil prices in the U.S. have increased approximately 38% since the end of September 2011. We then looked at the level of real economic growth in the year immediately following the oil price shock. The results can be found in Exhibit 4 below. While the 1970s oil price shocks ostensibly led directly to a decline in (much more energy intensive) real economic activity, the more recent oil shocks are not as conclusive. Of the past six oil shocks, four resulted in business as usual with economic gains over the next year in-line with or above the post-war median level of 3.1%. Two oil shocks coincided with a contraction of economic activity in the following year. However, it is not clear whether oil prices were to blame as the 1990 experience coincided with the savings and loan crisis and the 2007 experience involved the global financial crisis.
What appears to be a common denominator in recessions preceded by oil price shocks is a hawkish central bank. In these circumstances, high oil prices are coincident with strong economic growth and inflation risk leading to tighter monetary policy and heightened recession risk. In a June 1997 paper titled Systematic Monetary Policy and The Effects of Oil Price Shocks, current Federal Reserve Chairman Bernanke concluded that an important part of the effect of oil price shocks on the economy results not from the change in oil prices per se, but from the resulting tightening of monetary policy.
EXHIBIT 4: OIL'S RECENT IMPACT ON GROWTH MUTED
Source: Bloomberg, Haver Analytics, NTGI. Note: Euro Area proxied by Germany prior to 1995.
With the developed economies still in the midst of deleveraging from the global financial crisis, we think it is unlikely that developed country central banks like the Federal Reserve and the European Central Bank will raise interest rates due to current levels of oil prices. In addition, the inflation in commodities outside of oil is muted. While WTI oil has risen by over 30% since September 30, 2011, Brent crude is up 21% and key U.S. commodities have been better behaved. U.S. natural gas has fallen 39% and coal is down 19%, while corn is up 4%, soybeans have risen 16% and copper has jumped 20%. This more tempered overall commodity price picture increases the chances that central banks will view the current oil spike as non-inflationary and therefore prove less likely to react.
One reason for the muted impact on growth is the diminishing energy intensity of developed nations. Since 1976 the real price of oil has risen over 140% percent, but oil-related spending as a percentage of U.S. consumers total expenditure has actually decreased from 4.7% to 3.8%. This is largely explained by the substantial improvement in energy efficiency. Between 1976 and 2008 the fuel economy of U.S. passenger cars has increased from approximately 14 miles per gallon to 23 miles per gallon. Reflecting these trends across developed countries broadly, OECD oil consumption actually fell from 2000 to 2010 from 48 million b/d (63% of global consumption) to 46.4 million b/d (53% of global demand).
The story across the developing (non-OECD) countries is starkly different due to their rapid industrialization. For perspective, U.S. per capita oil consumption peaked at 30 barrels per year (b/y) in the mid-1970s, while Japan peaked at 18 b/y in the early 70s, and South Korea hit 19 b/y in the late 90s. Chinese per capita oil consumption is currently only 3 b/y, while Indian consumption is around 1 b/y. Strong non-OECD growth over the last decade has led to an increase in oil consumption from 28.5 million b/d (37% of demand) to 40.9 million b/d (47% of demand). This growth is expected to continue at a 2.5% annual pace over the next decade, compared to 0% demand growth in developed markets. When you blend both the developed and emerging economies together, you see that global energy intensity (the amount of energy used per dollar of GDP), has decreased by nearly 45% over the past 30 years helping mitigate the impact of higher oil prices.
But what about the impact of higher oil (and gasoline) prices on the consumer? Looking at U.S. economic data, petroleum represents about 37% of U.S. energy usage, while natural gas is 25%, coal is 21%, and nuclear and renewable total 17%. While gasoline prices have spiked of late, we have seen natural gas and coal prices drop sharply helping cushion the impact of high oil prices. This has resulted in energy costs as a percentage of personal consumption falling from 6% in the early 80s to 3.8% at the end of 2011. From 2003 to mid-2008, oil prices spiked from $36/barrel (real Brent prices) to $147/barrel, but total energy spending rose from 2.5% of personal consumption to just 3.2%. This supports the notion that the 2008 recession was not caused by the coincident rise in oil prices, but was a result of the global financial crisis.
EXHIBIT 5: A SMALLER SHARE OF WALLET
Source: Bloomberg, NTGI; personal consumption data though 1/31/2012. * real price of oil indexed to current price.
The historical experiences noted above help explain macroeconomic models, which predict a fairly measured impact on global growth from higher oil prices. The U.S. Federal Reserve models estimate a 0.2 % change in growth in both years one and two after a $10/barrel change in oil prices, a relatively benign impact. West Texas Intermediate oil was at $105/barrel at the end of March 2011, comparable to todays prices. Brent prices a year ago were $117/barrel, and have increased modestly to $123/barrel today.
To further understand the impact of oil prices on consumer behavior, we also looked at the relationship between year-over-year changes in gasoline prices and its impact on both consumer sentiment and behavior (measured by retail sales less auto and gas). We found gasoline prices had a slight (but not statistically significant) impact on confidence with the biggest impact on confidence coming at a six month lag. However, despite this slight negative drag on confidence, spending showed no significant relationship. In fact, the correlation between year-over-year gasoline prices and year-over-year retail sales (excluding gas and automobiles) was actually positive. Moreover, analyzing any potential lagged effects only lessened the relationship suggesting that any relationship between the two is spurious and that both gasoline prices and retail sales are driven by other factors such as overall economic growth. We did similar studies on absolute levels (as opposed to year-over-year calculations) over shorter time frames and the result was the same.
The resilience of retail sales to rising gas prices is likely a result of the overall environment in which gasoline prices rise. If the price increases are demand driven, stronger economic growth is likely, the employment picture should be improving, and consumer incomes should be rising. This helps offset the increasing prices at the pump.
EXHIBIT 6: THE "WORRIED" CONSUMER GOES SHOPPING
Source: Bloomberg, NTGI; data through 2/29/2012. *brought forward six months, **less auto and gas sales.
We have also examined the impact of rising oil prices on the stock market. Exhibit 7 compares the year-over-year change in oil prices against the corresponding year-over-year change in global equity prices. The scatter plot depicts a minor positive correlation between oil prices and developed equity returns; while emerging markets exhibited a stronger positive relationship. Importantly, the data sets displayed a rather large variation. For instance, when looking at environments where oil had increased by over 40%, returns in the U.S. stock market ranged from as high as 50% to as low as
-25%; this suggests that large increases in the price of oil have little impact on coincident returns. Oil prices versus subsequent six-month returns shows some negative relationship but again, the wide range of returns for a given change in the price of oil suggests other factors are at play in determining stock price movements.
EXHIBIT 7: STOCKS AREN'T (USUALLY) BOTHERED BY OIL
Source: Bloomberg; research is based on quarterly data from 1976 to 2011.
But all is not benign when looking at rising energy prices and the stock market. Separate research from Ned Davis Research indicates that investors do worry more than consumers, and stocks begin to struggle after sustained increases in energy prices. When the six-month rate of change of gas prices exceeds 20% (it is currently just above 0%), the stock market has gained just 2% per annum. Conversely, when the six-month rate of change is below 5%, the market has gained 11%. Similarly, when the 1-year rate of change in oil prices is above 33%, the stock market has fallen 7.5% per annum. When oil prices have been flat or falling, the market has gained 16% per annum. We dont believe these studies provide a definitive roadmap, as the prior episodes of rising oil and gas prices may have proven problematic because the central bank started tightening monetary policy. But they are a reminder that investors may discount the risk more quickly than shoppers.
In looking at sector performance, we do see some distinction in the way oil prices impact different industries. As one would expect, the most notable impact of oil prices is on the energy sector where a 10% increase in the price of oil has historically resulted in a 2.4% increase in the price of energy stocks. All other sectors show very little response to changes in the price of oil. Furthermore, the way in which the more cyclical sectors show up as winners and defensive sectors show up as losers suggest that the change in oil price may merely coincide with the influence the economic cycle has on stock prices. Finally, while the results shown below came from a separate study than shown in Exhibit 7, the conclusion that oil prices have a slightly positive (but mostly insignificant) coincident impact on the broader market is confirmed.
EXHIBIT 8: OIL ONLY DRIVES ENERGY SECTOR
Source: Bloomberg research is based on a regression analysis of monthly data going back to 1990.
We think the current high level of oil prices, while reflecting some risk premium for Iranian uncertainties, is mostly due to the tight state of global supply and demand. We dont think the current price levels are high enough to derail the (slow) global expansion, but a major spike tied to deterioration in the Middle East likely would. We think easy global central bank policy means that the history books will show this period to be one where oil prices rose but the economy did not go into recession, as financial conditions stayed easy and other commodity prices helped cushion the blow. The effect of high oil prices on the financial markets is less clear, as there is evidence to support both a benign and more worrying view. In general, investors will start to discount a worse economic environment if we sustain significant future price increases, but the current level of global oil prices should not be a deal-killer for growth or risk taking.
Special thanks go to Jackson Hockley and Kevin Cleary for their insights into the energy industry and to Natalie Sproull for data research.
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