Oil price spikes
February 26 2011
The past five global recessions have all followed sharp jumps in the oil price. Investors, traders and analysts this week have all been nervously asking: is a sixth imminent?
The shock in markets has been palpable as the Brent oil price jumped as high as $119.79 a barrel on Thursday, up 16 per cent on the week. With equity and bond markets having – until this week – focused more on the prospects of inflation, some investors now think fears of an economic slowdown could surface.
“In the stagflation debate, markets have been pricing for higher ‘flation’, but it is the ‘stag’ bit that hasn’t been priced in yet … All routes head in the same direction: threats to economic growth,” says Neil Williams, chief economist at Hermes, the UK fund manager.
A key part of the debate will be the ultimate size of the jump in oil prices. As oil prices stabilised on Friday at about $111.50, investors started to sound more sanguine about the outlook for equities, saying that a correction had been long overdue but could be short-lived.
“We see the market acting because of uncertainty, not because of a change in fundamentals. There are actually some good buying opportunities right now,” says Jonathan Xiong, senior director in asset allocation at Mellon Capital Management in San Francisco.
So far the jump in oil prices is nowhere near as large as during previous oil supply shocks. During the first Gulf war in 1990-1991, oil prices jumped 150 per cent in three months. In the 1970s, when oil supply was struck by a series of events, such as the Arab-Israeli war and the Iranian revolution, prices rose more than 200 per cent in a matter of months.
The Brent oil price was about 25 per cent higher at its peak on Thursday from late January, which is when traders say the crucial switch happened whereby the oil market switched from being driven by optimism about demand to concerns over supply.
Traders say that may be the extent of the gains in the price for the time being, with Saudi Arabia moving to make additional supplies available to the market. Ian Taylor, chief executive of Vitol, the largest oil trading house, said this week that “if Opec put more barrels into the market … then we do believe prices should stabilise below current levels and move back to a price range of around $90-$100”.
Echoing that sentiment, Torbjörn Tornqvist, chairman of Gunvor, the fourth-largest oil trader, says “a crude oil price of over $100 per barrel would not appear to be warranted given current fundamentals”.
All bets are off, however, if unrest spreads to another big producer. Mr Tornqvist adds that, given the situation in the Middle East, “the oil price is anybody’s guess”.
Most agree that volatility is likely to be high, since the removal of Libyan supply reduces the market’s buffer against further shocks – either to supply or demand. Oil volatility, as measured by the CBOE oil volatility index, has jumped by 38 per cent since the beginning of the week.
The action in other markets was less pronounced. The S&P 500 was down just 2 per cent on the week, while benchmark 10-year US Treasury yields dropped 0.15 percentage points to 3.43 per cent, benefiting from a flight to quality. The Swiss franc and yen both moved higher as investors sought safe havens.
Equity and bond investors, however, took different views about what persistently high oil prices would mean for markets. Matthew Garman, an equity strategist at Morgan Stanley, says oil passing $125 a barrel acted as a “choking point” for markets in 2008, but that they are more resilient now. He points instead to how recessions or severe growth scares follow an annual increase in oil prices of 85-90 per cent. During the past year, Brent crude prices have risen about 46 per cent.
Mr Xiong speaks for many in equity markets when he says that, unless oil goes to $130 or $140, the recent drop in share prices should soon subside. “Most likely this is going to be a temporary correction. This is a short-term pull-back.”
Bond investors are less sure, fretting not just about oil but also the ongoing problems in the eurozone. Corporate bond markets have been favoured by many fixed income investors, but this week have seen an increase in the spreads that companies pay. Hans Lorenzen at Citi says: “Oil may be the catalyst, but unwinds of crowded positions seem to be driving much of the widening in credit.”
Many worry that rising oil prices will soon feed through into higher inflation, raising the pressure further on central banks to increase interest rates. Mr Williams thinks that would be unjustified but that rate increases are still possible: “Given the geopolitics, how can higher mortgage rates bring down the oil price right now? I’m looking into next year and think that those central banks that tighten rates could see the shortest-lived hikes in living memory.”