So, last night oil got thumped, down 2%. Given the fall, and the prospect for further weakness, I thought it might be useful to ask, where oil might head to and what the implications are for this price trajectory.
The stakes could not be higher. There’s an opinion at large that the current slowdown in the US and, increasingly, global growth can be turned around if the globe’s automatic stabiliser, the oil price, eases. Gavyn Davies of the FT recently hung his hat squarely on this peg:
In summary, then, the decline in business surveys has been greater than occurred in the spring of last year, when the world economic recovery hit a temporary pot-hole. This is especially true in the manufacturing sector, which has continued to nosedive in the month of May, while the services sector seems to have stabilised. The good news is that, although the survey results have fallen sharply from the extremely healthy readings which were recorded in February, they have not yet fallen to anywhere near the levels which would trigger serious concerns about a double dip recession.
Clearly, markets are going to be extremely sensitive to what happens next. If manufacturing surveys start to advance as the Japan impact begins to reverse, then worries about a double dip will start to fade. If the downward momentum continues in manufacturing, and starts to undermine the strength of services, concerns about the recovery will mount rapidly.
Another excellent macro mind has recently emphasised the role of oil prices. Tim Duy reckons:
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Temporary weather and tsnumai induced disruptions for one, but we should be trying to look through such short term events. The crisis in Europe, although to be honest I don’t think this is having much of an impact on the decision making of the average US citizen or firm. I tend to think the rise in commodity prices, particularly oil, was the primary culprit, as consumer spending faltered and businesses struggle to pass increasing costs onto consumers.
In his recent speech too, Ben Bernanke dedicated a lot of space to the oil price, suggesting that with substantial falls, the way could be cleared for further simulus:
…gasoline prices are exceptionally important for both family finances and the broader economy; but the fact that gasoline price increases alone account for so much of the overall increase in inflation suggests that developments in the global market for crude oil and related products, as well as in other commodities markets, are the principal factors behind the recent movements in inflation, rather than factors specific to the U.S. economy. An important implication is that if the prices of energy and other commodities stabilize in ranges near current levels, as futures markets and many forecasters predict, the upward impetus to overall price inflation will wane and the recent increase in inflation will prove transitory. Indeed, the declines in many commodity prices seen over the past few weeks may be an indication that such moderation is occurring.
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So, let’s take a look at the oil price:
The above chart marks the key moments in the MENA (Middle East and North African) crisis. As you can see, each key event was accompanied by varying degrees of increased risk premium in the oil price. If we take a starting point of $88 in mid December when Tunisia sparked the revolution and a finishing point in early April, when the Libyan war was in its early stages and supply anxiety reached a peak at a price of $113, we get some notion of the risk premium currently built into the price: $25.
Of course, this is guesswork to the extent that the MENA crisis cannot be isolated from other factors acting upon the price. But it does give us at least a guide to how significant the risk premium is, if we accept that expected global growth rates were roughly consistent through the period.
It is also important to note that the recent 15% or so retracement in the oil price cannot be put down to any easing in the MENA crisis. Given a similar selloff occurred across the commodites complex, it looks rather more like a downgrading of global growth expectations that has driven the correction.
Further evidence that security of supply that is governing the current oil price can be found in the International Energy Agency’s monthly statistics. In early April, I wrote a post called Boom and Bust is back:
Like housing supply in Australia, commodity supply is inelastic. That is, it cannot respond quickly to a sudden surge in demand. The chart offered below (and mentioned above) shows the effects on any given market if supply cannot respond quickly. Don’t be scared of it, it is easier than it looks:
Q0 and P0 represent the initial equilibrium situation in any market. Initial demand is provided by D0, whereas supply is shown as either SR (restricted) or SU (unrestricted).
Following an increase in demand, such as a surge of emerging markets looking to engineer an historically swift catch-up in living standards through mass urbanisation, the demand curve shifts outwards from D0 to D1. When commodity supply is restricted, prices rise sharply from P0 to PR. By contrast, when supply is unrestricted, prices rise more gradually from P0 to PU.
The situation works the same way in reverse. For example, if there was a sharp fall in demand following a contraction like that of the GFC or an inflationary bust causing commodity demand to fall from D1 to D0, then prices fall much further when commodity supply is constrained.
The graph illustrates that demand shocks combined with inelastic supply do not result in a one way bet of upwards price movements. Rather, such economic settings produce volatility, with steeper price rises and spectacular collapses.
Why you might ask? It’s pretty simple. This is a mathematical representation of human panic. When a market is perceived to be unable to increase supply easily then speculators move in. In strategic markets like oil, governments begin to fret about security of supply. They stockpile. More speculators enter the market. So on, and so forth.
So long as the perception that supply is constrained remains, the frenzy continues until it exhausts itself in a new crash.
For the global economy, this dynamic is now apparent across a spectrum of commodities. None, however, is more important to the prospects and pattern of global growth than oil.
As I wrote recently, for much of the last decade, oil has been priced on the assumption that supply is in jeopardy of being unable to respond to burgeoning demand. The situation first arose in 2003 when, ironically, the US invaded Iraq:
As the graph shows, that invasion marked two vital turning points in the oil market. The first was that OPEC’s spare capacity became severely constrained on geo-political concerns and, second, it was the last time that the world saw oil priced in the $20 range, in my view, for good. From 2003 to mid 2006, OPEC’s spare capacity oscillated in a band between one and three million barrels per day and the oil price more than doubled from $30 to $80. For the following year, spare capcaity rose to four million barrels and the oil price corrected to $60. Then, as the last growth cycle wound itself toward its blowoff hase, and spare capacity dropped toward 2 million barrels again, the price skyrocketed.
In the IEA’s last report in May, OPEC’s spare capacity would have risen above 6 million barrels per day, however, it instead fell to 4.88 million barrels because Libyan spare capacity was removed from the equation.
So, if we’ve still got $20+ risk premium in the oil price, without it we’d already be returning to the sub $80 range that would enable further monetary easing in the US.
This suggests several speculative conclusions. First, unless global growth weakens significantly again, the downside limit for oil looks around $90. Second, the automatic stabiliser role of oil of removing comsumption power from deficit economies as growth rises and returning it as growth falls is going to operate in a wider band of volatility. Three, the current soft patch in US growth will need to get worse before we’ll see QE3.
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal.
He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.
