What is the economic impact of an oil price shock?

The economic news event of the weekend was the attack on the Saudi oil production facilities. It looks as though Houthi rebels and Iran were involved but forgive me if I am careful about such things along the lines of this from the Who.

Then I’ll get on my knees and pray
We don’t get fooled again

As you can imagine there was a lot of attention on the London oil price opening last night and no doubt fear amongst those who were short the oil price. Their fears were confirmed as we saw an initial flurry of stop loss trading which can the price of a barrel of Brent Crude Oil go above US $71 which was some US $11 higher. It then fell back to more like US $68 quite quickly. For those unaware this is a familiar pattern in such circumstances as some will have lost so much money they have to close their position and everybody knows that. It is a cruel and harsh world although of course you need to know the nature of the beast before you play.

Thus the first impact was some severe punishment for sections of the oil trading market. The rumour was that a lot of quant funds were short of oil and we will have to wait and see if there is a blow-up here. If we move on we see that the oil price has been falling this morning leaving the price of a barrel of Brent Crude at US $65.50 or up over 8%.So let us start by looking at the winners from a higher oil price.

Winners

A clear group of winners and presumably the group who have taken the edge off the higher oil price are the shale oil wildcatters in the United States and elsewhere.

“Since the last in-depth review five years ago, the United States has reshaped energy markets both domestically and around the world,” the IEA’s Executive Director, Fatih Birol, said at the presentation of the report on Friday, accompanied by U.S. Secretary of Energy Rick Perry. ( oilprice.com )

If we continue with this analysis here is some more detail.

U.S. crude oil exports have soared since the ban was lifted at the end of 2015, to reach 3.159 million bpd on average in June 2019, according to the latest available EIA crude export detail.

As you can see the impact of the shale oil era had one underlying effect last night and this morning via the way that Saudi production is not as important as it was. But also there is the economic model of the shale oil industry which I have pointed out before is more of a cash flow model than a profit one. So I would have expected them to rush to hedge their production last night and this morning. As it happens these levels are ones which would be profitable for them as their costs are often around US $50 per barrel. However they will not be making as much as you might think as they would have impacted more on the WTI ( West Texas Intermediate ) benchmark which is about US $5 lower than the Brent benchmark.

Other companies in the production business will also be winners and we see an example of that as the British Petroleum share price is up 4% at 523 pence today.

Next comes the countries who are net oil producers. We have looked at the US already and the position for Saudi Arabia is mixed as it is getting a higher price but has lower production. Russia is a clear winner as its economy depends so much on its oil production.

Exports of mineral products (consisting mainly of oil and natural gas) accounted for 59.2% of total Russian exports in 2016 (Rosstat, 2017).

There is quite a list of winners in the Middle East including ironically Iran assuming it will be allowed to sell its oil. Then places like Kazahkstan as well as Canada and to some extent Australia. There is also Norway where according to Norskpetroleum it represents some 16% of GDP and 40% of exports as well as this.

The government’s total net cash flow from the petroleum industry is estimated to NOK 251 billion in 2018 and NOK 263 billion in 2019

Thus I am a little unclear how Oxford Economics are reporting that Norway would lose from a higher oil price.

There are quite a few African countries which produce oil and Libya comes to mind as do Ghana and Nigeria ( assuming the output of the latter can avoid the problems there).

Another group of winners would be world central banks especially the ECB after its moves on Thursday. The reason for this is that they have been trying to raise the inflation rate for some time now and either mostly or entirely failing as Mario Draghi pointed out on Friday..

The reference to levels sufficiently close to but below 2% signals that we want to see projected inflation to significantly increase from the current realised and projected inflation figures which are well below the levels that we consider to be in line with our aim.

Should this transpire then we will no doubt see a shift away from core and the new “super core” measures of inflation which for newer readers basically ignore what are really important.

Losers

These are the net oil importers which are most of us. In terms of economic effect the standard view has been this from FXCM.

Data analysed by the Federal Reserve shows that a 10 percent increase in the price of oil is associated with about a 1.4 percent drop in the level of U.S. real GDP.

The 10% depends on the actual price but that has been a standard with the Euro area thinking there would be the same effect on it from a US $5 move. Of course these days the US would see more offset from the shale industry and I think worldwide the advance of renewable energy would help at the margins. But a higher oil price leads to a net loss overall as the importers are assumed to fall by more than the exporters rise. Geographically one thinks of China, Japan and India.

The effect on inflation is unambiguously bad and let me offer a critique of the central banking view above. The impact of inflation on real wages will make workers and consumers worse and not better off reminding us that central bankers have long since decoupled from reality.

Comment

There are a couple of perspectives here. The first is that in any warlike situation the truth is the first casualty. This leads to a situation where we do not know how long Saudi oil output will be reduced for, which means that we do not know how long there will be an upwards push on the oil price. Next comes a situation where looking ahead there will be fears that attacks like this could happen again. That is in some way illogical as defences will no doubt be improved but is part of human nature especially as we now know how concentrated the production facilities are in Saudi Arabia.

Another perspective is provided by the fact that the oil price is back to where it was in May and some of July.

Oh and central bankers used to respond to this sort of thing with interest-rate increases whereas later this week we are expecting an interest-rate cut from the US Federal Reserve. How times change…..

Podcast

Thank you to those of you who have supported this as the listener numbers on Soundcloud on Saturday alone exceeded any previous week..

 

11 thoughts on “What is the economic impact of an oil price shock?

  1. Hello Shaun,

    first thoughts are that this will be a counterpoint . If oil prices are sustained then a blip in prices will cause ………. dis-inflation! the market was weak already – take more spending power out and I’d posit that the recession will cause disinflation as companies seek buyers for their goods by cutting prices . to cause inflation people need more money in their pockets than whats needed to buy stuff they want – no sign of that yet.

    a long term price increase will or possibly will , herald the age of depression followed by New Age Feudalism powered by intermittent medieval renewables* and bicycles for all ( except for the elites ZIL lanes of course ) .

    Interesting times

    Forbin

    * its all we will have left ….

    • Hi Forbin

      Just before I read your comment I saw this by Bloomberg which is simultaneously mindboggling as well as being quite possibly true.

      Gone are the days when central banks would raise interest-rates into such an event. The irony is that they now claim to be inflation targeters, well apart from when it rises…..

  2. Short term a small impact as the Saudis were to cut supply in event due to world growth slowdown. Medium term even less impact if the world continues to slowdown and this morning China released a further decline in Industrial Production.

    I suppose its an excuse for dearer petrol at the pumps in the UK which we will all have to pay the more miles you drive the more you are hurt.

    This type of thing causes volatility elsewhere and its been voiced previously that the people responsible for these types of events making money on share prices and dealing in commodities but not sure how truthful that is.

    Lets be honest about all this the world will continue to spin round whatever happens.

    In other news the BBC has downgraded UK growth this year and next but I think the forecasts are optimistic;
    https://www.cityam.com/business-groups-say-brexit-impasse-hurting-firms-and-growth/

      • Hi Forbin thanks for the link.

        Another economic of the rise in oil is the importance of technological advancement in sola power, renewables, not to mention waste disposal, many things going to landfill should be recycled. Cut out waste and be more productive relying on energy by other sources than oil.

        Its just another evolutionary phase the world is going through and if its not concern over oil there will always be problems the world is confronted with.

  3. Great blog and podcast as usual, Shaun.
    You write: “Should this transpire then we will no doubt see a shift away from core and the new ‘super core’ measures of inflation which for newer readers basically ignore what are really important.”
    Actually, this has already been happening for a while. The original inflation-targeting central bank, the Reserve Bank of New Zealand, now publishes three measures of underlying inflation: sectoral factor model, trimmed mean and weighted median in addition to the traditional exclusionary measure based on the CPI excluding food and energy. Also, the exclusionary measure is treated as a second-class citizen, only appearing in a chart and not the table. The Bank of Canada gives more status to measures of underlying inflation further than most central banks and in 2017 replaced its exclusionary measure, CPIX, as its operational guide with three new measures: CPI-common, CPI-trim and CPI-median, which are closely related to their RBNZ counterparts. The US Fed still prioritizes an exclusionary measure, PCEPI less food and energy, but also calculates non-exclusionary measures. In particular trimmed mean measures calculated by the Dallas Fed seem likely to pluto PCEPILFE in the not too distant future.
    Rereading your blog, perhaps you were just saying monetary policy will focus away from measures of underlying inflation tout court, however defined. I’m not sure that would be a good thing. Monetary policy shouldn’t react to every drought and drone strike.

    • Hi Andrew

      You are entirely right that a monetary response is much more appropriate for a permanent rather than a temporary rise in inflation. For the simple reason that there is very little that can be done in the short-term due to the lags in any economic response. Also I mean the ordinary definition of temporary and not the central banking one.

      As to measures of underlying inflation there is nothing wrong with them per se and in fact they can be very useful. But central banks have gone overboard with their importance when it suits them or if you prefer they have cherry-picked from the data.

      As to Rik Ocasek RIP and here is my favourite.

  4. As you identified in last week’s soundcloud and previous questions of the EU bank seeking 800 mil, read (Google business nytimes) about repo rate action on Monday. Last happened (?$?) Jan 2 (normal). Tremors. Hmmm…

  5. FED (riddle): What is the sound of ‘One Hand Clapping?’.

    Possible Answer: Fed slapping bankers, hedge funds, pensions about their easy money/lending practices,hedge losses, unaccounted forex/investments/forays exposure?!?
    Smarten Up!!!!!

  6. ‘CaT”s got -cue song-‘White Rabbit’ -Jefferson Starship’- on screen monitor. Figure it out by morning data trolls-make my bonus-((‘insert appropriate ‘expletive’cultural noise’))…

  7. I always wonder why public hedge funds that publish their portfolio positions even exist?!? Their just asking for a ‘Bronx’ dark alley ‘chit kickin”!!!

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