Crude Oil at $70; A Top Down Analysis of its Impacts
Oil prices are currently rising to their highest levels since 2014 which begs the question; who wins under these circumstances?
Crude oil is up 14% YTD and like many economic events, certain parties will benefit at the expense of those less fortunate. Before dissecting who these parties are and the impact that this will have, it is imperative to first understand the catalysts to the situation:
- Global Growth (Demand Side): Until mid-April, surging oil prices were almost exclusively a by-product of demand driven factors. This is no surprise given that worldwide economic growth is at its highest level since 2011, further backed up by the world’s largest economy (USA) reporting strong April job numbers. This robust rise in demand has closed the supply glut we have seen in recent years.
- Geopolitical Tension (Supply Side): The markets have seemed to price in interferences within Iran’s exports given President Trump’s restoration of sanctions on the country. Less pronounced impacts include the current rumblings associated with Venezuela’s upcoming election on May 20th and the Saudi`s championing of a push to further tighten the market leading up to OPEC`s June 22 meeting.
Specifying whether impacts are demand or supply driven is important, as it helps in answering the question “who wins” when prices hit $70 and above. A demand driven price increase is seen as desirable given that it is a by-product of a strong global economy. Supply shocks are often a negative indication given its tendency to retract such growth through reducing discretionary household income and thus diverting capital from more productive uses. The discussion that follows takes a top down perspective to commentate on what rising oil prices mean for various players within the economy:
A. Central Banks:
The level of importance that society places on oil’s functionality means that price variability will impact the macroeconomy through various means. Despite policy makers often focusing on core inflation indexes, which remove the impact of energy costs, sustained rises in oil prices have the potential to eventually make its way to increasing the price levels within the transportation and utilities industries. If prevalent enough, unexpected inflation may become a reality, instigating wealth redistribution from debtors to creditors, amongst many other unsolicited impacts. This is where central bankers can step in to remedy the situation through the use of monetary tightening via interest rate hikes or open market operations to moderate the inflationary pressure.
When looking at what higher oil prices mean from a country’s perspective, two factors rank high in relevancy; the nation’s balance of trade pertaining to oil and current account. Take India for instance, who’s rupee has been amongst the worst FX performers in 2018. Coupled with this is the fact that oil is one of the nation’s largest import items. If oil prices continue to rise, India’s current account deficit will only further widen. This deficit will further exert downwards pressure on the rupee. Counteracting this requires intervention, such as the aforementioned interest rate hikes, however, doing so disincentives the productive investment required to sustain growth in a developing nation. Thus, it is clear that the current oil situation fuels a viscous loop that positions India as a nation that is adversely affected.
On the opposite side of this spectrum are major exporters such as Saudi Arabia and Russia, who will evidently benefit through the larger revenues that these higher prices will yield. This especially benefits Saudi Arabia, as it will provide positive momentum for Aramco’s scheduled IPO. Across the Atlantic, the USA should be less impacted when compared to historical standards and retain domestic stability due to their shale oil production hedging the adverse GDP effects associated with such price increases. Russia and OPEC committed to cutting 1.8 billion barrels per day last year, and the high prices this pact has helped trigger coupled with the USA’s larger output is allowing the Americans to penetrate the European market share. This doesn’t mean that they are home safe, however, as the nation still runs a trade deficit with regards to oil.
Energy stocks have been amongst the S&P 500’s top performers, up 12% in the past month and 5% YTD despite the broader market remaining predominantly stagnant. After initial concerns that US shale production was increasing at a rate that would lead to excess reserves of years prior, sentiment has eased. Overinvestment has historically been a major concern for energy investors, as adverse price shocks to oil could cause a firm’s capital intensive investments and exploration to be significantly unprofitable. Despite this, Q2 of 2018 has seen companies spend less and instead return profits to shareholders in the form of buybacks at a rate 5 times that of just a year ago. Key to this bullish sentiment are prices staying within oil’s “Goldilock Zone” of $60 to $80. If kept within this range that is not low enough to create a glut whilst simultaneously avoiding the damping of demand, energy companies and their investors will continue to benefit from higher revenues.
Economies that are more dependent on consumer spending to generate GDP will have exposure to adverse externalities associated with these price increases. Despite there being a shift towards more efficient modes of transportation with the introduction of hybrid and electric vehicles, higher prices for oil ultimately reduce the amount of disposable income available to be spent. Additionally, prices of heating could also eat into the pockets of household. The USA has already seen consumer spending slow, growing at its weakest level in nearly five years at 1.1%. With incomes staying stagnant, and the cost of living increases, widespread decreases within consumer spending can become a reality.
In conclusion, geopolitics mixed with standard economic fundamentals is driving the price volatility of oil. Economic sanctions, mixed with Aramco poised to be the largest IPO of all time means that there will be plenty of externalities that will keep this debate relevant for the months to come. Thus, the question over whether or not oil will be sustained at such prices is one without a clear answer.
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Writer: Matthew Leonelli
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