Disclaimer: Views in this blog do not promote, and are not directly connected to any Legal & General Investment Management (LGIM) product or service. Views are from a range of LGIM investment professionals and do not necessarily reflect the views of LGIM. For investment professionals only.

Oil be damned

The attack on two Saudi oil facilities has led to a spike in oil prices and delivered another shock to a world economy already suffering from a plethora of downside risks. Is this the tipping point towards recession?

The Saudi attacks apparently top the biggest disruption in oil supply history at 5.7 million barrels per day. The 19% intraday price move on Monday 16 September was the largest since 1991.

This represents a pure negative supply shock – the worst kind of shock – resulting in less oil output and higher prices. Higher oil prices caused by stronger demand would be less of a problem. Our modelling work suggests that the impact on growth from shocks tends to be multiplicative rather than additive. Economies can cope with one or two shocks if they are otherwise robust but there are thresholds which, once breached, can set off recessionary dynamics.

This shock comes at a time when global manufacturing is already stagnating and the world has become increasingly reliant on the consumer as the sole engine of growth. Could this engine be about to stall, given that consumers are the main loser from high oil prices, which squeeze real incomes?

Oil producers will benefit, while for Saudi Arabia the effect is ambiguous depending on how much output drops versus the higher price it will receive for what it can still produce. But the net effect is clearly negative even before considering that the marginal propensity of oil producers to spend is typically lower than that of the global consumer.

Well oiled

So that is all rather gloomy so far, except that the scale of the shock is much smaller than it first appears. The oil market is significantly larger than in the past so the disruption as a share of the oil market is smaller than previous major shocks. Crucially, everything hinges on how long the disruption to oil supply persists. The peak disruption was large but temporary. Production is already being partially resumed and idle capacity fired up. Customers are also being supplied using special reserves.

Whether it takes a few weeks or months to fully normalise production remains uncertain. But what matters is the intention to increase production and the price reaction. After an initial surge, prices were only up around $6 or 10% after the first day. Assuming this is the price which sticks over the next few months, this is barely noticeable over any longer period. For example, prices fell by around 10 times this amount in 2014.

While we saw this as a positive development at the time, it did not lead to an economic boom (though economists fiercely debated the proportion driven by a positive supply shock from surging US shale oil production versus weakening demand). So why should a tiny reversal of this price decline be adverse?

 

                                                 

 

Econometric models calibrated on previous oil price shocks will tend to overestimate the damage. The 1970s experience was especially problematic because the sustained and massive rise in oil prices led to second-round effects on broader wage and price-setting behaviour. The surge in inflation forced up interest rates, exacerbating the downturn. Today, there is no concern about inflation and central banks are more likely to ease policy in response to higher oil prices.

Second, oil dependency has declined globally. Finally, the US no longer relies on oil imports from the Middle East. Given the disproportionate weight of the US in global financial markets, this reduces the risk of contagion from rising oil prices. Even if prices were to rise by 20% and remain at this level until the end of the year, we would be surprised if this took more than 0.1% off global GDP growth.

Still, this shock comes at an inopportune time and we will be keeping a close watch on oil prices and the potential for geopolitical tension in the area to cause further disruption. However, we remain much more concerned about developments in the trade war. Recent tension has eased at the margin and the market seems to be expecting at least a ceasefire. Problems in the Middle East might even make the US and China less inclined to battle each other over trade, but there are significant risks that talks break down, leading to the imposition of the next round of tariffs. This would raise the threat of recession.