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Beware oil price volatility

Beware oil price volatility

Oil has a habit of reminding investors of the geopolitical risk premium attached to its price.

Following a sophisticated attack on two major facilities in Saudi Arabia, the oil price spiked nearly 20 per cent in September for its largest one day move since the Iraqi invasion of Kuwait in 1990.

However, we believe this spike is significant only if it is sustained and we see a more meaningful gain in the price over time.

Meanwhile, the direct effect on the global macroeconomic picture is far from clear.

While oil does affect inflation and growth it is far from the primary driver, and higher oil prices can impact countries in very different ways.

In addition, supply and demand considerations cannot be ignored, and these factors are not cause for alarm at present.

 

While the situation is certainly fluid, we are not jumping to any conclusions on the longer-term price trend of oil based on a thus far delimited - if dramatic - event.

If higher oil prices persist due to major supply shortages this would be a headwind for global growth, but even this would be unlikely to tip the balance on the overall growth trajectory.

Similarly, some investors fear the impact of oil on inflation.

But while the relatively subdued oil price has certainly contributed to lower inflation since mid-2014, low inflation is a structural issue and oil is not the determining factor here.

In the US, a higher oil price does negatively impact the consumer, but it also boosts capital expenditures in the US energy sector, effectively reducing the impact of oil’s inflationary pressures.

In addition, some evidence suggests that the link between oil price shocks and inflation is not as strong as it once was.

The US Federal Reserve’s explicit inflation fighting mandate, and other factors such as lower energy consumption per dollar of GDP, has weakened that relationship since the common association of the oil shocks in the 1970s with stagflation.

That is not to entirely discount the effects of the oil price on growth, but any sustained upward shift would have disparate effects globally.

There are two sides to the coin.

Firstly, oil producing nations benefit from higher oil prices, and the currencies of major oil producers like Russia and Canada jumped on the news.

Conversely, major consumers in emerging markets, such as India, South Africa, Turkey, and Indonesia are hurt by a higher oil price (unless this is largely growth rather than supply driven), as this exacerbates current account deficits and weakens already vulnerable currencies.

The decline of over 40 per cent in the crude price in the fourth quarter of 2018 was a major tailwind for emerging markets in the early part of this year, and while the price has recovered from the $42 trough, we are not seeing prices at the point where they have a major impact.