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Oil shock waves – what does it mean?

Supply shortages?

The Middle Eastern turmoil, which originated in Tunisia, has quickly spread to a number of nations in the region. Escalating unrest in Libya, the regions ninth largest oil producer, has prompted the most serious concerns about a current oil supply shortage as it is estimated that we could be looking at a 75 per cent reduction in their output. Whilst this seems extraordinary, their total annual production equates to around 1.5 million barrels of oil a day which could be comfortably covered by OPEC’s current spare capacity. So if it’s not a physical supply shortage, then what is driving prices so much higher?

Essentially, the market is anxious about the risk of contagion. A significant disruption to the production capabilities of the regions oil powerhouses, Saudi Arabia and Iran, would have dramatic implications for world supply.

Saudi Arabia is the world’s largest oil producer at around 10 million barrels per day, and it controls around one fifth of the world’s total proven oil reserves. In response to the regional protests, King Abdullah has announced a US $36 billion stimulus package to help secure the support of his citizens. Signs of discontent in Saudi Arabia are minimal and a major violent uprising is generally not considered a likely scenario.

Iran on the other hand, the regions second largest producer, appears less stable. The disputed election results of 2009 and subsequent bloody protests suggest that all is not well and Iran arguably poses the most serious threat to global oil security.

What does a higher oil price mean for economic growth?

Oil prices will always remain an important macroeconomic variable as an increase in prices can inflict substantial damage on the economies of oil-importing countries and on the global economy as a whole. Higher oil prices bring inflationary pressures through higher energy and input costs, which weigh on both producers, as well as the disposable incomes of consumers.

Despite the rapid ascent of China, and other emerging nations as energy consumers, the US still dominates the world’s consumption of oil by a significant margin. A price hike in oil in turn impacts the consumer. This may not be palatable for an economy that is still in the early stages of recovery with elevated unemployment, a weak housing market and a consumer market showing only minimal signs of life.

Real supply shortages have caused economic turmoil on more than one occasion. The 1970’s is well documented with more than one oil shock that was the result of real supply issues. Separate to these events however, rises have tended to occur during times of economic growth resulting from increased demand. However these current price rises are occurring in a period of tentative economic revival, excess capacity and low inflation. This may result in businesses not being able to pass through all of their increased costs as they fear this would result in falling demand for their products. As a result, higher oil prices could erode margins as well as push up inflation.

Where to next?

The economic threat posed by higher oil prices remains real. Fears of short-term supply shortages and political tensions in the Middle East could continue to drive up prices even further. However oil remains a geopolitical asset with positive longer term supply and demand dynamics and consequently forms an important part of a truly diversified equity portfolio.

– article courtesy of Zurich Investment Management

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