Moment of Surrender: Regimes Fall, Oil Prices Spike
by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
February 28, 2011
Key points
- Geopolitical tensions swell along with oil prices, pushing the stock market lower.
- The absence of a longer-term oil-supply shock suggests the price spike could be short-lived.
- Consumers will take a hit, but the broader economy should avoid a double-dip recession.
In this unprecedented time of ordinary people rising up to do the extraordinary—toppling multiple governments in the Middle East—we look at what the reverberations mean for the market, economy and energy sector.
My thanks go out to my Schwab colleagues Michelle Gibley and Brad Sorensen for their input on this report. It's also been invigorating to dust off my energy analyst cap because I covered the sector as a portfolio manager for many years in the late 1980s and 1990s.
Protests for democracy, especially among the younger generation, have spread beyond Egypt and Tunisia to other countries with oppressive governments, skyrocketing food inflation and high unemployment.
Last week gave markets a crude awakening as geopolitical tensions and $100 oil prices dominated the business headlines:
- Brent Crude (European, African and Middle Eastern oil that is exported to the West) oil prices moved into triple digits last week on Libyan unrest, before settling back at week's end.
- The US benchmark, West Texas Intermediate (WTI), has been more subdued (explanation later in the report).
Oil Prices … 2008 Redux?
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Source: FactSet, as of February 25, 2011.
Our initial impression is that the move in oil prices is likely overdone for several reasons. There appears to have been much panic-buying and speculation in the run-up. Already, the Saudi Arabian government has said that it can step in and fill the void left by the supply disruption in Libya, which accounts for only 2% of global oil output.
This, of course, is contingent on unrest not spreading to Saudi Arabia. King Abdullah is a popular figure and a new $36 billion package of social benefits may keep unrest at bay. But, there remains the possibility of uprising by the Shiite Muslim minority, which constitutes 75% of the population in the eastern province, and which is also home to key oil fields.
In addition to the Saudi response, the International Energy Agency (IEA) said it stands ready to release emergency stockpiles if needed, and officials from the Obama administration have stated that the Strategic Petroleum Reserve can be tapped, as well.
The bigger fear is that the oil supply upheavals spread. Bahrain, Yemen and Algeria are small producers, each with less than 2% of global oil output. But Iran produces 4.6% of global supplies.
US supply glut
While oil imports from the Middle East and North Africa (MENA) are important, Canada and Mexico are the top two sources of foreign oil for the United States. In fact, there's a supply glut in the United States, which explains the record-wide $16 spread between Brent Crude and WTI prices.
Inventories at the Cushing, Oklahoma delivery point for light sweet crude in the United States are elevated due to higher US oil production, rising imports from Canada and lower refinery utilization. This excess has kept a lid on WTI prices. The spread could narrow but is likely to remain until several new pipelines are built during the next couple of years.
Due to this bottleneck issue at Cushing, Brent Crude prices are likely a better gauge of demand for oil globally. Additionally, prices at the pump, even in the United States, are more closely tracking Brent Crude prices.
We do have access to energy sources on domestic soil in the form of oil shale deposits and natural gas, but significant production from these sources are some time away because of environmental concerns, powerful oil lobbies and lack of political will.
The impact on other parts of the world is greater. In the euro-zone, Italy takes one-third of Libya's oil production, Germany takes one-tenth, and Spain and Switzerland jointly take another one-tenth.
The impact in China is significant, too: 50% of its imports are from the Middle East and an additional 30% are from Africa. What's unique, though, is that the Chinese government controls prices at the gasoline pump. It can delay pushing through price increases and force refineries to operate at a loss.
Short-term problem?
Importantly, much of the tension in the Middle East stems from economic turmoil, rendering it unlikely that leaders of these countries would want their main revenue source cut off for any length of time.
As for the protesters and possible future leaders, were they to disrupt production facilities, they would likely lose public support very quickly.
It is impossible to predict the outcome from geopolitical unrest, but outside of larger-scale conflicts, the most likely scenario is that oil-supply disruptions will be short-term in nature.
In fact, despite spiking spot-oil prices, the message from the futures market is that this is a short-term phenomenon, with longer-term prices below current prices.
Economic impact
Even before the latest outbreak in geopolitical unrest, oil prices were rising due to the improved economic outlook. Current forces behind rising demand include strong emerging economies and improving US growth, creating synchronized global growth.
We believe we are also on the verge of much-better jobs reports, which could feed into a self-sustaining economic cycle and, thus, higher oil demand.
But what is the tipping point for oil? At some point, rapidly rising commodity prices of nearly all varieties ultimately sow the seeds of their own destruction via rising supplies and weaker demand.
It's hard to know when that's going to occur, although the consensus is that $120-130 oil would start the process.
In the meantime, Bank Credit Analyst (BCA) estimates that every $10 increase in the price of oil shaves economic growth by 0.1-0.2% … not significant at this point, but it will add up if oil prices continue to rise.
We do know that most recessions have been preceded by oil-price spikes. You can see this laid out in the chart below (the shaded bars are recessions).
Recessions Often Follow Oil Spikes
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Source: FactSet, as of February 25, 2011. Plotted on logarithmic scale.
There are a lot of comparisons being made to the most recent oil price spike in 2008. But there are important differences between then and now. The US economy was already in a recession at that point, with the employment and housing fundamentals in breakneck declines.
Today, we're in a time when the economy has already moved from recovery to expansion, and unemployment claims are down significantly.
In addition, the manufacturing sector was in freefall in 2008. Today, it is extremely strong, with the reading this week likely to show even further acceleration.
We believe the most apt comparison is not to 2008, but to 2003 when oil doubled to a then-record $40 per barrel, in response to the invasion of Iraq.
Fears of a double-dip recession were rampant then, but the strong leading economic indicators gave the correct signal that the expansion was intact. I would argue that case for today, too.
Leading Economic Indicators Much Stronger vs. 2008
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Source: The Conference Board and FactSet, as of February 25, 2011.
Consumer impact
The percentage of disposable income consumers devote to energy purchases is approaching 5.8%, up from just over of 4% at the end of the recent recession. That's shy of the high of more than 6% in 2008 but over the average level enjoyed from 1985 through 2005.
So, there remains some room in consumers' budgets to absorb the increase in energy prices. However, it's the speed of any additional energy price increases that will be important to watch. Consumers tend to ignore gradual increases, but react more to sharp changes in prices.
In addition, increased energy efficiency has somewhat reduced the dependence of the economy on oil. In the early 1970s, US energy consumption as a percentage of gross domestic product was about 16%. Today it is less than half of that.
Federal Reserve to react?
The more-bearish economists are suggesting that a continued spike could trigger a double-dip recession and/or talk of a third round of buying back Treasuries also known as quantitative easing (QE3) by the Fed. We think economic momentum is sufficient to avoid the former and certainly hope the latter is not in the cards.
The weakness in the US dollar, which is likely partly due to the Fed's second round of quantitative easing (QE2 in November of 2010), has contributed to the surge in commodity prices (they move inversely).
Why would the Fed want to exacerbate that problem with a policy (QE3) that would likely weaken the dollar further? What's more likely is a lengthier phase before the Fed considers raising interest rates.
The Fed is only likely to react by raising rates if job growth improves meaningfully and rising wages suggest a filtering of high oil prices through to generalized price increases.
Market impact
In addition to fears about oil prices and their economic impact, there is a fear that rising geopolitical tensions could cause a general flight out of riskier assets, like stocks.
There is precedent for quick and sharp oil-price spikes to precede market corrections. Historically, there have been seven instances when oil prices have jumped more than 10% in a two-day time period, with the average decline of the stock market being about 9% during the subsequent six months.
Oil Spikes Often Bring Market Indigestion
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Source: Birinyi Associates, Inc., as of February 28, 2011. Dates represent the end of the two-day oil spike.
As we've been noting, the market sentiment conditions (too much bullishness) were suggesting increased stock market vulnerability, and we saw that with last week's 3% decline in the S&P 500® index.
Absent a significant further oil-price shock, we think the cyclical bull market will continue. The two key supports for the stock market—strong earnings and accommodative monetary policy—remain intact.
As such, for those investors who remain underexposed to US stocks relative to their long-term target allocations, we would recommend using any further market weakness to buy stocks at lower prices.
Sector Snapshot
As for which segments of the market look most favorable in a high oil-price environment, according to Ned Davis Research:
- The Energy sector is a clear beneficiary, on which we have an outperform rating.
- Materials is next on the list, on which we have a marketperform rating.
- At the bottom of the list are Consumer Staples (underperform), Telecommunication Services and Health Care (both with marketperform ratings).
You can also read our complete Schwab Sector Views, which provide our analysis and recommendation for all 10 sectors.
A note to contrarians: Sentiment about oil prices has become a bit one-sided. According to SentimenTrader, traders in the Rydex family of funds have piled as much money into the energy sector as they ever have.
Oil prices have generally not moved higher in the past when that's happened, though geopolitical concerns can often trump historical sentiment readings.
The good news from a broader sentiment perspective is that optimism has waned significantly with the current geopolitical unrest and last week's stock market drop (sentiment works in a contrarian way). Those improved sentiment conditions set up a healthier market environment.
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