USD200 OIL SUPER SPIKE – WHAT ARE THE CONSEQUENCES?

MOST analysts laughed when Goldman Sachs predicted that oil would go to USD100 a barrel more than two years ago. Brent crude is around USD124 a barrel at present. Crude prices have doubled in a year and risen six fold since 2002. Now Goldman Sachs is suggesting USD200 on the upside of a super-spike within the next 24 months. This figure has also been mooted by some members of OPEC. Given the fundamentals on both demand and the supply side international-ly there is a chance that the super-spike may well take place. The oil price is still rising and may get much higher than where we are at. World oil prices rose 1.4 percent recently, extending further into record territory amid intensifying worries over tight world supplies of diesel fuel. A US government report showed a decline recently in distillate inventories – which include diesel and heating oil – that brought stockpiles in the world’s biggest energy consumer nearly 13 percent below a year ago.
Sovereign Stock-Piling
The growth in demand for oil in Asia – particularly in China and India – and amongst oil producers in the Middle East and other commodity producers in Africa and Latin America is still strong. Many countries are protecting their consumers through subsidies and controlled prices to a remarkable degree from the recent oil price increases so their consumers are not making the necessary downward adjustment. Despite the fact that the American economy is slowing down – their petrol demand is down by about three percent over the past year – it does not appear to have an impact on the global fundamentals and the oil price continues to rise because of Sovereign stock-pilling in anticipation of rising demand. Beyond USD100, the speculative component many be such smaller behind the oil price rise in comparison to the real demand and supply fundamentals, which are both severely constrained.
Rising Inflation
The inflationary implications globally of a super-spike in the price of oil are significant. After a couple of years of low single digit inflation many countries are suddenly into low double-digit inflation and it is eroding real purchasing power. Interest rates may have to rise to curb double digit inflation, which will create a real squeeze. A recovery in stocks and credit market assets since early April has shifted investor focus to inflation risks from surging fuel, food and other commodity prices, which can erode corporate profits and cause the world’s central banks to raise interest rates step-by-step.
Demand Downturn
Given the supply constraints, the only development which is likely to see a pullback in the oil price is some kind of quite extended global recession that dampens demand significantly. With the possibility of a super-spike looming, most economic sectors, and especially the manufactures, are finding it extremely difficult to plan for the future or even stand still in the hope that there will be an upturn in global forecasts. Many business plans, profit margins and budgetary allocations are under water in terms of viability. With every passing month, industry is facing ever harsher challenges, as the price of fuel and raw materials continues to climb.
Conclusion
There is an extremely synchronized concatenation of global risks manifest in the three way convergence of the fuel, food and finance crises. Far from being isolated they are extremely interlinked. On the financial side, the price of equities is based on forward earnings calculated on the back of discounted cash flows. If future profit margins are going to be severely eroded by the oil super-spike, then the price-earning ratios at present – which look low based on historic date – are in fact extremely high in terms of future projections. Especially as earnings are revised downwards. On the food side, the agriculture industry has an extremely high dependence on oil and oil-based products because of farm mechanization as well as the use of fertilizers. Food processing, storage and distribution is also extremely energy intensive. The bio-fuel production is eating into human food supply chains. This is an extremely mis-guided development. All in all the convergence of the “3F” crises – fuel, food and finance – is going to be extremely difficult to out-manoeuvre without a severe reduction in growth expectations. On the positive side, humanity may adjust its efficiency and consumption of carbon-based fuel significantly post the oil super-spike and in the process help the global environment!
(Courtesy: ATCA Dialogue)