Musings: Recession Threat Due to Higher Oil Prices Grows

The recent and growing civil unrest in Libya has raised the specter for an explosion in crude oil prices, the possibility of a supply cutoff and a potential global recession. These increasing fears come despite statements from Saudi Arabian oil minister Ali Naimi that the world is adequately supplied with crude and that his country stands ready to boost production to prevent a spike in world oil prices such as happened in 2008. He did acknowledge that recent oil price volatility will continue to be experienced in the near term but would fade as market participants recognize the large amount of surplus production capacity available to offset any supply shortfall coming from the problems of Libya's oil industry.

At the present time, Libya produces about 1.6 million barrels per day, or about 2% of world oil supply. It is a major supplier of oil to Italy accounting for about 24% of that country's oil imports in 2009. In addition, there is a major pipeline, Greenstream, from Libya to Sicily and then onwards to the Italian mainland that hauls natural gas from Libya. The pipeline supplies about 10% of Italy's natural gas demand. According to media reports early last week, Eni, the Italian oil and gas producer, has shut the pipeline due to the violence in Tripoli, but assured customers that it could still meet gas demand. The media was also reporting that western oil companies, including BP, Shell, Total and Suncor, to name just a few, had shut down their activities and were evacuating their employees and dependents from the country. The Nafoora oil field is reported to have been shut down due to worker strikes along with the Rus Lanuf oil refinery on the coast in the Gulf of Sirte. Repsol, the Spanish oil company, announced it had shut down the El-Sharara oilfield that pumps about 200,000 barrels per day, or roughly 13% of Libya's daily production.

It is interesting that world oil markets were slow to react to the growing civil unrest and government protests throughout the Middle East until they arrived in Libya. Then oil prices started jumping. On December 18, 2010, Brent crude oil traded at $91.67 a barrel when protests against the leadership in Tunisia first broke out. By the time Tunisian President Ben Ali resigned on January 14th, Brent had risen in price to $98.68. But oil prices then retreated to $95.25 on January 25th when the protests first started in Egypt. Prices subsequently rose as the Egyptian protests grew, reaching $101.43 on February 13th, the day that Egyptian President Hosni Mubarak resigned. Oil prices rose the next day when violent civil protests erupted in Bahrain and Iran, but then actually fell when Libyan protests first emerged. On February 22nd when Eastern Libyan cities fell to protesters and gun fire was reported in the capital of Tripoli and Libyan Leader Moammar Gadhafi declared he would fight to the death against his opponents and threatened civil war to crush his opponents, Brent's price jumped to $106.26 a barrel, up 8%. In the U.S., the new April WTI crude oil futures contract closed up $5.71 a barrel at $95.42. Prices for both Brent and WTI were moving higher on Wednesday of last week when we wrote this article.

Exhibit 1. Oil Prices React To Libya's Civil Unrest
Oil Prices React To Libya's Civil Unrest
Source: The Globe And Mail

The biggest problem with the reduction in oil supplies as oil companies depart Libya is their impact on global oil markets and the potential impact on future economic activity. One analysis we saw pointed out that the jump in WTI prices since the end of the prior week to mid last week was the equivalent of a $0.13 per gallon increase in gasoline pump prices in the U.S. That will push the average gasoline pump price close $3.50 per gallon and in high-priced localities to $4.00 or more. We have found from previous studies that when gasoline pump prices breech the $3.50 per gallon barrier, driving is impacted as the cost of fuel takes a bigger share of consumer incomes. The $0.13 per gallon jump from higher crude oil prices was suggested to cost the typical American car driver $1,086 a year in additional expense, a not insignificant tax on consumer spending. As can be seen from the chart in Exhibit 2, whenever we experience a sharp jump in oil prices, there tends to be a recession in the immediate future. As the chart shows, since the late 1970s there have been five official recessions with sharp increases in oil prices immediately before four of the five. Only the 1981-83 recession was marked by falling oil prices, but that recession was the result of sharply increased interest rates as the Federal Reserve, led by Paul Volker and supported by President Ronald Reagan, waged a successful war against inflation that had gotten out of hand during the 1970s.

Exhibit 2. Oil Prices At Risk Of Triggering Another Recession
Oil Prices At Risk Of Triggering Another Recession
Source: Gluskin Sheff

The question on economic forecasters' minds is whether the sharp rise in oil prices this time will also cause a recession. Some forecasters are calling for $200-300 a barrel oil prices as a result of the worst case political scenario for the Middle East. Other market experts suggest that there is a $10-15 per barrel risk premium in the current price of Brent crude oil for the worst case scenario, which could disappear if the unrest settles down. At the present time,

forecasters are sanguine about the Middle East civil unrest spreading to key oil producers such as Saudi Arabia and Kuwait. But as Robert Mabro, president of the Oxford Institute for Energy Studies put it, "This whole event has been so surprising. I don't smell any danger in Kuwait, Saudi Arabia or Abu Dhabi, but things are so unpredictable you never know.''

It is interesting to note that world oil prices in real dollars are now inching above the $40 per barrel level that helped trigger the two worst recessions since the Great Depression of the 1930s. Crude oil prices crossed that magical $40 per barrel threshold in late 1979 in response to the removal of Iran's oil supply from the world's market following the overthrow of the Shah of Iran's government, and then again in 2008 when speculation helped drive crude oil prices to $147 per barrel just before the financial crisis erupted causing a collapse in global economic activity. This is not a positive scenario if the violence in the Middle East continues or spreads and crude oil prices remain high or climb higher.

Exhibit 3. Real Oil Prices At Trigger Point Of Recessions
Real Oil Prices At Trigger Point Of Recessions
Source: Gluskin Sheff

Most oil industry forecasters don't expect the Middle East turmoil to spread to the major oil exporting countries and remain sanguine about the outlook for crude oil prices. They give little chance for violence to breakout in Saudi Arabia. However, King Abdullah, the aged ruler of Saudi Arabia, has just returned home following three months away for treatment for medical problems. He has announced a plan for distributing $36 billion in the form of raises for workers, grants and other awards to Saudi citizens in order to help improve their current plight, and retain their allegiance. This approach, as we learned recently when visiting Oman, is followed by the country's Sultan who lavishes money and benefits on his citizens to make sure they are happy and less susceptible to radical elements in the Islamist movement. Yet we heard there were still demonstrations by Omanis during the recent rash of demonstrations in countries around the Middle East. Opponents of the Saudi royal family were disappointed that only money was distributed and not any political freedom.

People listening to Saudi Arabian oil minister Naimi stating that OPEC had 5-6 million barrels a day of surplus productive capacity and would use that to keep oil prices under control must focus on both the reality of how real that surplus figure is and how quickly its use could impact the market. We suspect, but can't prove, that much of this surplus could come on stream over a 90 – 180 day time period, not tomorrow. The odds are that the additional oil is not of the quality that has been lost from the violence in Libya, making it less the salvation it appears on the surface. Still, once any additional Saudi production is brought on stream, it will take time for it to reach markets, which probably explains why the Kingdom was meeting at the end of last week to plan to boost its production by several hundreds of thousands of barrels. We keep thinking that we've seen this movie before, and we didn't particularly like the ending.