Oil’s surge could ruin economic recovery

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The surge in the oil price due to the conflict in Libya and revolts in other MENA countries prompted me to ascertain the impact thereof on the world economy and especially the U.S. The most important factor regarding the global economy is consumer sentiment. When confidence wanes consumers are less inclined to spend. But what really has broken the back of consumer sentiment in the past?

Let us first take a look at oil. Looking at the history since 1980 it is evident that at times when the price of crude oil (Brent spot) moved significantly higher compared to prices a year previously, consumer sentiment started to weaken. The oil price spikes were all event driven.

1980 – Iran/Iraq war started

1990 – Iraq invasion of Kuwait

2001 – Britain and U.S. raids on Iraq

2008 – Great bear market squeeze

2011 – MENA uprisings.

Sources: I-Net; Conference Board; Plexus Asset Management.

But it is not always the case, though, as sometimes consumer sentiment rose despite rising oil prices.

Affordability of petroleum energy obviously plays a major role in consumer sentiment. To calculate this affordability I calculated the number of barrels of crude oil used to produce the monthly U.S. Total Gasoline All Sales/Deliveries by Prime Supplier as published by EIA by applying the conversion number of 42 gallons per barrels. The total was then multiplied by the spot price of Brent crude and expressed as a percentage of total retail sales.

Sources: I-Net; FRED; Plexus Asset Management.

My analysis indicates that although surges in oil prices on an affordability basis were sometimes responsible for consumer sentiment dipping, it is the Fed’s foregoing monetary policy actions that eventually led to breaking the back of consumer confidence.

In the second half of 1987 the Fed started to tighten monetary policy by raising rates steadily as consumer sentiment improved. In March 1989 the Fed started to ease as consumer sentiment waned. The already weakening consumer sentiment was aggravated by Iraq’s invasion of Kuwait, which saw the oil price surging. In February 1994 the Fed again started to tighten monetary policy by raising its base rates as the improvement in consumer sentiment seemed sustainable. The final Fed hike in the cycle in June 2000 was followed by a surge in the oil price, which dented consumer sentiment only to be followed by 9/11. In the next cycle the Fed started to hike rates in the second half of 2004 through August 2007 as oil prices continued to surge. Consumer sentiment had already started to wane when speculative market actions led to a further blow-off in the oil price followed by the Lehman saga and subsequent Great Global Liquidity Crisis.

Sources: I-Net; Conference Board; Plexus Asset Management.

The bottom line is that in each of the previous economic cycles the Fed’s actions eventually led to weaker consumer confidence, only to be aggravated by either an energy crisis or confidence crisis such as 9/11 or the Lehman saga.

A very interesting observation is how closely the affordability of oil prices as measured by my calculated U.S. crude oil consumption as percentage of retail sales has tracked the Conference Board’s Consumer Sentiment Index since September 2008.

Sources: I-Net; Conference Board; Plexus Asset Management.

But what oil price levels can be tolerated by the U.S. economy before it will turn into a crisis and see consumer sentiment plummeting? I have used three constant Brent oil price scenarios against an assumption that monthly retail sales will grow by 5% on a year-ago basis:

High: $160 per barrel

Neutral: $120 per barrel

Low: $80 per barrel

Sources: I-Net; Conference Board; Plexus Asset Management.

With the current oil price close to the neutral scenario, it implies that oil affordability is already close to the 2008 all-time high. Furthermore, if the oil price remains at the current level it means that around 9% of retail sales will soon be spent on oil compared to around 6% in November last year or the equivalent of $10 billion more than in November. On an annualised basis it will detract approximately 0.9% from the annual nominal GDP!

But wait for it! Should the oil price rocket to the high scenario of $160 per barrel, around 12% of retail sales will be spent on oil – the equivalent of $20 billion more than in November and detract 1.7% from the annual nominal GDP. Yes, that would be a major crisis!

The impact on the U.S.’s real GDP is even worse due to the inflationary affect of the higher oil price. With shelter currently still in the doldrums my analysis indicates that the fit between the year-on-year U.S. CPI inflation rate ex shelter and changes in the oil price compared to a year ago since January 2007 is nearly perfect.

The current spot price of Brent crude of approximately $120 implies that the U.S. CPI ex shelter inflation rate is likely to move to 4% and higher in coming months if the oil price is maintained at this level. Assuming that shelter, which constitutes approximately 32% of the U.S. CPI, stays unchanged, it means the overall year-on-year CPI inflation rate will increase to 2.7%. A sustained level of Brent crude of $160 per barrel will take the year-on-year CPI ex shelter inflation rate to around 7% and overall CPI inflation to 4.5% if shelter remains unchanged.

Sources: I-Net; Bureau of Labor; Plexus Asset Management.

What does it mean for real U.S. GDP growth?

In the case of Brent crude staying unchanged at $120/barrel, my analysis indicates that year-on-year GDP growth could shave off nearly 1 to 1.5% of the headline number. In the case of $160/barrel, GDP growth will actually decline in real terms – threatening a double-dip recession.

Any sustained surge in the oil price in fact acts as additional taxes levied on the U.S. consumer. Although I previously argued that the Fed is likely to hike the Fed funds rate in the third quarter as a result of improved consumer sentiment, the current state of affairs in the oil market together with increased geopolitical tensions is likely to force the FOMC to delay such action. Recent calls by some Fed governors to suspend the buy-back program of treasuries are to my mind premature, especially in light of the significant threat of rising oil prices due to the MENA/Libyan situation.

Yes, I continue to treasure my gold bullion holdings. Perhaps it is time to buy some calls on U.S. bonds and puts on the S&P 500?

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1 comment to Oil’s surge could ruin economic recovery

  • Frank W

    Didn’t Bernanke say that the oil price will have little effect on US inflation and that the price rise will be temporary. Qaddafi is already trying to exit Libya. He only wants the opposition to guarantee safe exit for his family. He also wants to keep his money. What’s holding up his exit is the opposition, which refuses to accept any of his conditions. The opposition is in charge of the part of Libya, which has all the oil. As for consumer sentiment, I doubt that it has any effect on anything. A number of statistical analyses by economists have demonstrated that there is no correlation between consumer sentiment and any financial factoor. The corelation work was done on both a contemporary basis and a forward basis.

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