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Oil's surge could ruin economic recovery

10 March 2011 Plexus Asset Management

The surge in the oil price due to the conflict in Libya and revolts in other MENA countries has prompted Dr Prieur du Plessis, chairman of Plexus Asset Management and author of the Investments Postcards blog, to determine the impact thereof on the world economy and especially the US. 

According to Du Plessis, the most important factor regarding the global economy is how consumer sentiment will be impacted. “When consumer confidence wanes, consumers are less inclined to spend. It is thus important to ascertain what has previously broken the back of consumer sentiment,” he said.

Consumer sentiment sometimes dips due to surges in oil prices on an affordability basis, which is calculated as the value of the number of barrels to produce the sales of gasoline in the US compared to total retail sales. However, it is the Fed’s foregoing monetary policy actions that have eventually led to breaking the back of consumer confidence.

“In each of the previous economic cycles, the Fed’s actions eventually led to weaker consumer sentiment, only to be aggravated by either an energy or confidence crisis such as 9/11 or the Lehman saga,” said Du Plessis. 

But what oil price levels can be tolerated by the US economy before it will turn into a crisis and see consumer sentiment plummeting? Du Plessis 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

With the current oil price close to the neutral scenario, it implies that oil affordability is already close to the 2008 all-time high (see Graph A).

If the oil price remains at its current level, 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.

If the oil price rockets 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!” Du Plessis said.

According to him the impact on the US’s real GDP is even worse due to the inflationary effect of the higher oil price. “With shelter currently still in the doldrums my analysis indicates that the fit between the year-on-year US CPI inflation rate ex shelter and changes in the oil price compared to a year ago since January 2007 is nearly perfect (see Graph B),” he said.

“The current spot price of Brent crude of approximately $120 implies that the US CPI ex shelter inflation rate is likely to move to 4% and higher in coming months if the oil price remains at this level. Assuming that shelter, which constitutes approximately 32% of the US CPI, stays unchanged, 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,” said Du Plessis.

What does it mean for real US GDP growth? In the case of Brent crude staying unchanged at $120/barrel, Du Plessis’s analysis indicated that year-on-year GDP growth could shave nearly 1% to 1.5% off the headline number.

“In the case of $160/barrel, GDP growth will actually decline in real terms, threatening a double-dip recession,” Du Plessis warned.

How should you position your investments in this environment? To go overboard and liquidate all your equity investments is a major risk on its own, as some easing of the conflict may force massive liquidation of oil by speculators, causing a major pull-back in oil prices, said Du Plessis.

Conversely, doing nothing is also a major risk if the conflict turns for the worse, forcing oil prices significantly higher.

“I would suggest a balanced approach by having gold bullion and defensive stocks in your armament,” said Du Plessis. “Unit trust holders can achieve the same by concentrating on those funds that have stood the test of time by providing solid returns at below-average risk levels”. 

 

Graph A

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

 

Graph B

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

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