Beware of the Fallout from Oil Market Supply Shocks

February 28th, 2012 by

It’s déjà vu, all over again. About this time last year, energy prices began climbing, and those gains contributed to the stock market’s swoon in the second and third quarters of 2011. Now, as the United States and the European Union seem prepared to aggressively challenge Iran over that country’s pursuit of nuclear power facilities (and possibly nuclear weapons), oil prices are soaring once more. That’s not surprising: even though no supplies have been interrupted as yet, saber-rattling over embargos rattles the nerves of investors and speculators alike.

Given this drama in the energy market, can another stock market slump be far behind? This year, at least, global sovereign debt woes appear to be at a less critical juncture, given the recent bailout package for Greece. The fact that the US economy appears to be on a more even keel also helps. But the fact that Brent crude oil futures contracts closed above $120 a barrel last week for the first time since June can’t simply be shrugged off.

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As the chart above shows, global stock prices and Brent crude oil futures (a proxy for the complex of crude futures contracts and cash prices) have been increasingly correlated of late, with oil prices rising in tandem with stocks whenever there have been signs of better economic data from the U.S. or reduced anxiety about eurozone government finances. That’s when crude oil is responding to economic fundamentals: its price rises or falls in response to actual or anticipated increases or decreases in demand on the part of users.

What is happening today is different – it’s a move in the price of oil that is tied more to the uncertainty regarding future supplies than it is to what will happen to demand. That’s bad news for stock markets, as you can see from the correlation chart above. Last winter, when the “Arab Spring” protests began in Tunisia and rippled throughout the Middle East, concerns about crude oil supplies drove energy prices higher – about 30% higher in the first four months of 2011 – but broke the correlation with stocks, which slumped in response. A repetition of that pattern – a supply-driven price shock to the oil market – may mean that stock prices suffer.

A spike in the crude oil price isn’t great news for the US economy, either, as can be seen in the chart below. Sharp upward spikes in the price of crude oil, represented by the gold line, are often followed by equally notable declines in the rate of real GDP growth in the United States.

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The question dominating economists’ minds is the extent to which the United States and other countries are able to cope better with a sudden rise in the price of oil that is driven by supply worries rather than increased demand. The optimists suggest that improving U.S. labor market conditions, combined with the fact that other commodity prices appear relatively soft compared to their own increases of a year ago, may help soften any blow. The apparent easing in inflation also will permit central banks worldwide to continue to provide liquidity, helping national economies and, ultimately, stock markets.

Still, a lot will depend on the nature of this and any future price spike in the energy market. If the move is short-term and more psychological in nature – anticipating a future supply shock that doesn’t materialize – or if other oil-producing nations move quickly to replace lost Iranian output in the market, then the blow to national economies and stock prices will remain more muted. But by their very nature, a sudden supply shock poses a significant risk to growth. So don’t be surprised to see a flurry of reports from economists and other pundits, chronicling each step taken to try to resolve Iran’s dispute with the West in the weeks and months.

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