As unrest drives oil prices up, stock prices could fall

SERIOUS MONEY:TURBULENCE IN the Middle East and North Africa (Mena) region has contributed to a jump in the oil price to more than $100 a barrel, the highest reading since the middle of 2008 and not far below the levels in real terms that were registered following the outbreak of war between Iran and Iraq in 1980.

Crude prices have more than doubled over the past two years and are up ninefold from the lows of the late-1990s to levels that have previously been followed by waning economic momentum and stock market weakness.

The historical record shows that all but one downturns in the US economy over the past 60 years have been preceded by a sharp increase in energy prices and each of these episodes was accompanied by a bear market in stocks.

The recent surge in the price of crude, alongside heightened political risk, has contributed to an uptick in stock market volatility and a decline in equity prices, albeit modest, which suggests investors are unsure as to whether history is set to repeat.

It is important for investors to appreciate that the relationship between oil prices and stock market returns is not straightforward. The stock market response depends on whether the increase in crude prices is driven by demand or supply shocks in the oil market.

Positive shocks to the demand for crude precipitated by global economic expansion are typically accompanied by higher stock prices, while negative shocks to oil production that cause an increase in precautionary demand are associated with negative stock market returns.

The sizeable increase in oil prices between 2003 and the summer of 2008 was driven primarily by unexpectedly high growth in emerging Asia, arising from the economic transformation of China and India. The two countries accounted for almost 40 per cent of the increase in world oil demand over the period and the positive shock saw spare capacity drop to record lows.

The price of crude registered a more than fourfold increase over the period, but the demand-driven rise proved positive for stock prices as the global economy registered its strongest and most enduring performance in more than three decades. The positive correlation disappeared during the spring and summer of 2008, as speculative demand caused prices to surge in the face of deteriorating fundamentals.

The high prices placed a heavy burden on already-stretched household budgets in the developed world and the positive correlation reappeared as both oil prices and stock markets dropped sharply against a background of deep economic recession.

The new millennium bull market in oil was unlike previous price shocks, which emanated from crises that temporarily removed important sources of supply. Indeed, the Suez crisis of 1956, the Yom Kippur war of 1973, the Iranian revolution of 1979, the onset of war between Iran and Iraq in 1980, and the Persian Gulf War of 1990 were all supply-side crises. Each of these episodes was followed by economic recession and accompanied by a bear market decline in stock prices.

It is worthy of note that it is not the disruption to crude oil supplies per se that triggers the negative stock market response, but the sharp increase in precautionary demand precipitated by fears concerning the future availability of oil supplies.

Upward shifts in precautionary demand typically have an immediate impact on crude prices and need not be accompanied by actual cutbacks to physical production for stock market weakness to unfold.

Indeed, the cumulative loss of output during previous supply shocks was typically less than anticipated, as production increases elsewhere compensated for the shortfall, but the supply reality was overwhelmed by the price increase driven by precautionary demand and stock prices dropped in sympathy.

The surge in oil prices from their 2009 low has been driven primarily by a positive demand shock emanating from emerging Asia. China and India are the chief incremental consumers of black gold once again. The two accounted for almost 40 per cent of the increase in world oil demand last year and their combined share of global consumption has jumped from just 9 per cent in 2000 to 14½ per cent today.

The unexpected positive shock to demand has, not surprisingly, been accompanied by higher stock prices.

Developments in the oil market, however, turned unfavourable in recent weeks as the social unrest in the Mena region that began in Tunisia last December reached Libyan soil and erupted in civil war.

Although Libyan oil accounts for less than 2 per cent of global output, tensions are running high throughout the region. Saudi Arabia has felt compelled to lead a coalition force into neighbouring Bahrain to calm the unrest – a development that could potentially lead to a confrontation with Iran.

The volatile situation in the Mena region is virtually impossible to forecast, but an upward shift in precautionary demand is almost certain. The historical record suggests the impact on stock prices will be negative. Caution is warranted.

charliefell.com