Should we worry about oil prices?

The risk of supply disruptions has fuelled fears that oil prices will surge. Are such fears reasonable?

Although not all oil price shocks historically led to recessions, all recessions (as identified by the US National Bureau of Economic Research) are associated with an increase in the price of oil, as oil prices have spiked at the onset of each downturn. The average real crude price during recessions has been 42 per cent higher than in normal times.

An oil price shock is rarely good news for oil-importing economies. Increased prices act as a tax on consumers, create ‘bad’ inflation (not related to a healthier economy) and slow growth. And the current economic climate makes increased investor vigilance with respect to a potential oil shock particularly justified.

With US households drowning in debt and savings rates very low, the private sector cannot be expected to maintain the same level of real spending should energy prices rise significantly.

On the corporate side, higher oil prices would squeeze demand, raise input prices, weigh on margins – and are typically associated with widening credit spreads. Thus, access to liquidity would be further restrained in already tight credit conditions.

Iran’s refusal to give up its nuclear ambitions, and the resulting EU embargo and US sanctions, could lead the country to respond by shutting the Strait of Hormuz, which hosts approximately one-third of the global trade in oil.

However, such fears are probably overdone. First, the US has the military resources to unblock it, probably within two weeks. Second, shutting the Strait would also penalise China, and Iran cannot afford to lose one of its biggest customers. Third, US strategic reserves and Saudi Arabia’s spare capacity are sufficient to make up for the potential shortfall in oil.

US Strategic Petroleum Reserves have increased by 1,412 per cent over 32 years, and the number of consumption days they can cover has risen from 2.5 in 1978 to almost 37 today, making the US much less dependent on imported oil in the event of a temporary supply disruption.

In addition, most Opec nations have developed spare capacity in order to align production with their perception of supply and demand. Estimates of Saudi Arabia’s spare capacity stand at around 2.5mmb/day, while Iran’s production level is about 4.3mmb/day. Therefore, Saudi’s spare capacity can cover close to 60 per cent of the shortfall should all of Iran’s production disappear from the market.

Adding the release of some of the US’s 704.7mmb of strategic reserves, and the possibility that other Opec members might raise production, we feel that solutions can be implemented sufficiently fast to avoid long-lasting effects on global prices.