Recent turmoil in the Middle East has contributed to a surge in oil prices. While prices began to march upward in the last several months on the back of improving global economic conditions, threats that a supply disruption coming from a strategically important oil producing country sent prices higher by more than 10 percent in just the last week.
The situation, if contained to the countries that have so far been afflicted with riots and protests, should not have a sustainable influence in the oil markets. Libya accounts for only 2 percent of global oil output while Algeria, Bahrain and Yemen are also relatively small producers. It is a dislocation of supply coming from Iran at 4.6 percent of global supply, or Saudi Arabia at more than 10 percent of world production, that would be problematic for economic and financial conditions.
At this juncture pundits are long on explaining what is happening. However, the shortcoming, which is where the most value lies, comes in handicapping how this turns out given the intensity of the fervor circling the political arenas of the most vulnerable regimes.
With already tight supply conditions, oil prices were vulnerable to a shock that would cause a swift uptick. Until now, the global economy has overcome prices hovering in the mid-$80/barrel range. It has been estimated that a 10 percent rise in oil prices equates to a 0.5 percent decline in global growth if occurring over an extended period of time. As such, a lengthy move above $100/barrel could trim 1 percent or so off growth, which is quite material given the current pace of economic activity, particularly among advanced countries such as the U.S., Britain and Europe. It is likely that the deflationary impact brought on by the choke-hold of elevated prices would be enough to snuff out the momentum some economies were beginning to build. The money spent on gasoline and other energy costs would siphon funds from being spent on others goods and services, sending the benefit to back to the same troubled areas that were at the root of the cause.
An announcement by the Saudi's that they would pump the incremental supply necessary to fill the void left by a shut down in Libyan oil production was reassuring and the markets seems to accept their ability to do so by selling oil prices down below the $100/barrel threshold. In the near term, the stock market will continue to fluctuate to the daily display in the Middle East until in proves innocuous or at least less important should another eruption occur because other news trumps its influence.
We believe that the equity rally that has been underway for two years will remain intact, if a major spike in oil prices is avoided. The thrust for equities has been twofold - improving profitability and a low cost of capital via exceedingly accommodative monetary policies. Global growth should be able to overcome the drag caused by $100 oil. That in turn will foster the climate for corporate profitability to increase. As for the more hawkish central bankers in the U.K. and European Community, the notion of tightening rates so close to the potential of an oil shock, may keep them sidelined for an extended period of time.