An Excerpt from the March 2011 Longbrake Letter
by Bill Longbrake
Executive-in-Residence at the Center for Financial Policy
Global Oil Price Shock
During the last month we have been reminded why economic forecasting is so difficult. That is because it is nearly impossible to anticipate consequential events that can shock the global economy and force a fundamental change in direction. The revolution in Tunisia, regime change in Egypt, civil war in Libya, unrest in Bahrain and chaos in Yemen were surprises that few, if any, anticipated. And the repercussions these events have unleashed are far from spent. Like a nuclear chain reaction, each event has emboldened people in other Arab countries to challenge long-entrenched, unpopular regimes.
Broadly-based political crises of the sort that are current underway in the Middle East are not unlike global financial crises. Both often times seemingly erupt without warning and their virulence takes most by surprise. However, upon closer examination, it becomes clear that unsustainable imbalances had built up over time and what had passed as stability was an increasingly fragile and unstable situation vulnerable to abrupt correction. Once the spark is lit, conflagration quickly ensues because the rot of persistent and large imbalances provides ample fuel. Tunisia was the spark and now the conflagration rages.
Political imbalances, like economic imbalances, correct but the process usually is a messy one and can take a long time to unfold. Furthermore, political intervention, as is also true with economic policy intervention, can prevent complete correction of an imbalance and can set in motion nascent imbalances.
There are several things that make the current Middle East political crisis especially worrisome and will bedevil economic forecasters. First and foremost among them is the global oil price shock that the crisis has spawned. It is a simple fact that energy hungry emerging economies have been driving up demand for oil faster than new sources of supply can be found. While this fact has been well understood and has been behind forecasts of rising oil prices, what is new is that civil war in Libya has reduced supply by 1.5 million barrels per day, which equals about 30% of OPEC’s spare capacity of 5.2 million barrels per day, and perceived threats to interruption of supply in other Middle Eastern countries have combined to lift oil prices by more than 20% in a few weeks time. Algeria is a prime candidate for interruption of 1.8 million barrels per day in exports. While not much in the news, protests have been underway in Algeria since late December and foreign policy experts consider the Algerian situation to be very fragile.
It is impossible to foresee precisely whether the oil price shock is temporary and will fade away as civil war in Libya is resolved and a semblance of political calm returns to the rest or the Middle East or whether political upheavals will continue and spread and result in persistently higher oil prices and perhaps at much higher levels than those that prevail currently.
By and large most Middle Eastern countries have not participated in accelerating economic growth that has engulfed most of the world’s emerging economies. This naturally leads to the question of whether the new political order that eventually emerges in the Middle East out of the current crisis will provide the kind of leadership which fosters more rapid economic growth or whether religious theocracies of the sort that currently rules Iran will emerge. And, there is also the question of the longer-term Middle Eastern balance of power between the political ambitions of Iran and the rest of the Arab nations. Oil, for better or worse, is the key to economic power and thus is the prize for which those who are seeking political dominance aspire.
All of these forces are in play. We cannot with any certainty know where they will lead as they interact with each other. What we do know, as we have learned from the recent global financial crisis, is that once the process has begun there will be new events and further disruptions. All we can be certain of is that volatility has increased and will continue unabated for a period of time.
Risks to the U.S. and Other Economies Posed by Global Oil Price Shock
Europe appears likely to be affected adversely to a much greater degree than the U.S. for several reasons. First, the lost Libyan oil is predominantly low-sulfur “sweet” crude, which goes mostly to Europe. While Saudi Arabia has the capacity to increase oil production to close the shortfall created by the loss of Libyan oil, it is “sour”, high-sulfur content crude. Unlike the U.S., Europe has little capacity to refine high sulfur content crude, so the replacement of lost supply is far from perfect. That is one of the reasons that a large price gap has opened up between the Brent and West Texas Intermediate (WTI) oil prices. As of March 12, 2011 WTI was about $101 per barrel while Brent was $114 per barrel. Prior to the crisis Brent averaged about $1 more per barrel than WTI. Another reason that the price of WTI has not escalated to the same extent is that the current ample supply of natural gas in the U.S. is an effective energy substitute and it is currently cheap and abundant. Europe does not have access to cheap U.S. natural gas. The impact of the Libyan situation will be the greatest for Italy, which is not a happy prospect because Italy is not totally immune from possible sovereign debt issues.
Second, commodity prices have a greater impact on measured inflation in Europe. For a variety of reasons unrelated to oil prices, inflation had already been rising in Europe, so the run up in oil prices simply exacerbates matters. Unlike in the U.S. where the Federal Reserve has a dual policy mandate covering both inflation and employment, the European Central Bank (ECB) is only responsible for limiting inflation. That mandate lead to the untimely increase in European interest rates in June 2008 just prior to the worst phase of the global financial panic. The ECB is once again telegraphing the likelihood that it will have to raise interest rates to contain inflationary pressures.
Third, if the ECB raises interest rates, this most certainly will have two consequences, both negative, for the peripheral European members of the European Union (EU) that are struggling with sovereign debt problems. First, higher oil prices and interest rates will depress economic growth and second, higher interest rates will increase the cost of sovereign debt. The first will depress tax revenues, the second will increase expenditures. Already, in anticipation of the next round in the on-going sovereign debt crisis, interest rates have risen on sovereign debt to levels that are simply not sustainable without intervention of some sort. In other words, it is not a matter of whether but when financial crisis will engulf Greece, Portugal, Spain and perhaps other European countries.
While the consequences in the U.S. are likely to be lesser in scope, they are not trivial. Already, consumer optimism has plummeted, although this has yet to show up in reduced consumer spending.
There will also be consequences for emerging economies because most are net importers of oil. The increase in oil prices that has already occurred is expected to have a modest negative effect on global growth over the next two years. But, further escalation in oil prices would result in much greater damage to global growth.
What to watch for is that when shocks occur, if they persist for any length of time, consequences will emerge and those consequences will set in motion responses that could have further adverse impacts on the global economy.
Read the Full March 2011 Longbrake Letter.