Highlights:– Historically, oil shocks have preceded US recessions
– Limited possibility of a repeat of similar oil shocks
– Central banks may look through inflation data even if there is a temporary surge
– Unprecedented liquidity measures already under way
– Aramco event raises risk premium; FII fund outflows may extend to India
Oil shocks have almost always been ominous for the global economy – not only because of their links to the economy but also because several US recessions have been preceded by a sharp surge in oil prices. Even when an oil shock has not led to a recession, it has undoubtedly had a negative impact on oil-importing economies.
Chart: Oil price trajectory and US recession periods
Source: Federal Reserve Bank of St. Louis
Note: Shaded areas indicate U.S. recessions
The murky politics of the Middle East has been the originator of all oil shocks and the current one is no different. The attack on Saudi refineries has raised the scary prospect of an escalation of Iran-US military skirmishes and the risk of large-scale disruption of oil production in the region. Interestingly, Saudi Arabia may itself want to keep oil prices elevated due to its weak fiscal situation.
Chart: Breakeven price of oil so that Saudi Arabia’s fiscal budget remains in balance
Source: Federal Reserve Bank of St. Louis
Oil prices are already up ~22 percent from their lows and, given subdued global growth, it raises the spectre of stagflation, which may ultimately lead to a recession.
So what will oil prices do? There are three possible scenarios for oil prices in the near term: 1. Remain elevated at current levels; 2. Surging past $ 80 per barrel and trading in a range of $ 80- $90; and 3. Moving past the $ 100 per barrel mark.
But we think there’s a fourth option and one that’s the most likely to happen: oil prices would normalize to their earlier levels, as global demand has slowed down substantially. Further, dependence on OPEC supply has been lowered over the years and with new supply coming from the USA, temporary disruptions such as the attack on Aramco can be handled, albeit with a lag.
Moreover, a potential supply outage from Iran, in case of possible escalation of Iran-US tensions, may not be a significant factor as the world is gradually getting used to doing without Iran’s oil. Iran’s production has substantially decreased from 3.755 million barrel per day in Sept 2018 to 2.19 mbd in August 2019.
Of course, much depends on how the current crisis escalates from here and how quickly Aramco repairs its facilities. Any military escalation would obviously have an impact on the oil supply route from the Strait of Hormuz, which controls oil flows of about 21 million barrel per day.
Even so, the current crisis may not lead to a recession. That’s because in most earlier oil shocks, the surge in price has been more than 100 percent, which is unlikely this time. And in today’s low-inflation world, together with trade wars and a sluggish global economy, demand for oil is in any case muted.
Chart: US recession periods and Oil price surge
Source: Federal Reserve Bank of St. Louis, Moneycontrol Research
Indeed, most central banks are grappling with consistent undershooting of inflation targets. They would also look through the impact of a temporary surge in prices due to an oil shock.
What’s more, global central banks are already positioned for looser monetary policy which should partially offset growth headwinds arising out of any rise in oil prices. While the European Central Bank re-starts its QE (Quantitative program) programme along with further cut in deposit rates, the US Federal Reserve is expected to cut rates again at its ongoing meeting.
Note that in the last one and half months, 27 central banks have opted for policy rate cuts. The last time central banks across the world lowered rates to this extent was seen post GFC (Global Financial Crises) in 2007-08.
Chart: Net no. of policy rate hike by the global central banks
Source: Moneycontrol Research, www.cbrates.com
Chart: Historical trend of net no. of policy rate hikes by the EM central banks
Given US President Trump’s pragmatic approach in dealing with what the US calls rogue states (Iran, N Korea), there seems little chance of a full scale military conflict. But whether there could be tactical warfare is anybody’s guess. This leads to an additional risk premium for the both portfolio managers and central banks. Central banks may have to factor in another “what if” risk scenario while considering monetary easing. Uncertainty is already high due to the trade war.
In the medium term, elevated geopolitical risk in the Middle East is likely to nudge further diversification of central banks’ reserves towards gold. Also, it adds to merchandise trading/investment in currencies other than the US dollar. Earlier this month, China and Iran agreed to a $400 billion investment deal targeted at developing Iran’s oil, gas and petrochemicals sectors in next the five years—a deal that is likely to be executed in yuan.
In the near term, implications for oil importing nations such as India are negative in terms of FII flows. Further, the usual talk about fund flows from the Middle East to India picking up when oil prices remain elevated is missing. This is because, over the years, particularly after the turmoil in early 2016, the share of Sovereign Wealth Funds in FII’s assets has declined.
This has partly to do with a weaker outlook for the oil market, wherein the structural changes in the energy world (Shale Gas, new supply, electric vehicles) may have dimmed the investment appetite of Middle-East based SWFs.
So, even in a scenario of elevated oil prices for an extended period, we may not see resumption of higher Middle-East fund flows to India. The only silver lining is that the share of relatively sticky fund flows from pension funds has increased for India. Pension funds’ share in FII equity assets have increased from 6 percent in Jan 2016 to ~8 percent now.
Table: SWF share in FII’s equity assets in India
Source: NSDL, Moneycontrol Research