Standard Life Investments

Published Article

Citywire - Beware Rising Oil Prices


 

Just at the time when several economies are beginning to show a noticeable improvement in business activity, resulting in analysts upgrading profits forecasts for a range of cyclical and financial stocks, a dark cloud is appearing on the horizon – the threat of much higher oil prices. The cost of Brent oil has risen to a nine month high, breaking out of the rather tight trading range of about $100-110 per barrel which has been seen for the past year or so. There have been supply disruptions in a number of countries, for example Libya, but very clearly the focus of market attention is recent events in Iraq. The sudden appearance of ISIS is not just threatening the partition of Iraq into three areas, the Kurdish north, a Sunni west linked with rebellions in Syria, and a Shia dominated south and east.

The real threat for oil supplies would be a collapse of larger parts of the country into renewed civil war; Iraq has the fifth largest proven crude oil reserves in the world, and surpassed Iran as the second largest producer of crude oil in OPEC at the end of 2012. Although Saudi Arabia could partially offset any decline in Iraqi exports, there is concern amongst many analysts that its room for manoeuvre is more limited than it admits in public.

Time to brush off those models about the impact of oil prices on the world economy! The general rule of thumb is that a permanent $10 per barrel increase in the oil price, reaching say $120 for Brent, would reduce global growth by about 0.25%. This sounds small, except that the world economy is only expanding about 3% a year. It should be emphasised, however, that subsequent oil price moves have cumulatively more effect, as consumers face a larger squeeze on spending power or businesses cannot pass the costs on so easily. Very sharp rises in energy costs – say a 50% rise in the cost of Brent - are often associated with recessions, as seen in 1973, 1979 or 1990. Sector rotation is significant at such times, away from consumer discretionary, such as airlines and autos, and towards resource stocks but also more defensive shares. Financials may benefit more this time, as at this stage of the business cycle central banks would probably keep policy loose, focusing more on the downward pressures on growth than the upward pressures on inflation.

Andrew Milligan, Head of Global Strategy, Standard Life Investments

First published in Citywire Wealth Manager – June 2014