04/03/2011: Oil price surges on gushing liquidity

One consequence of ongoing turmoil in the Middle East and North Africa, now with the moniker “Arab spring,” is the surge in oil prices since the beginning of the year. In New York, the price of a barrel of West Texas Intermediate (WTI) recently surpassed the 100 US dollar level, and in London the price of a barrel of Brent flirted with 120 US dollars.

Investors and traders are concerned about the Libyan supply, which represents some 2% of world production. This could be absorbed by the spare capacities of other oil producers readily enough, but if the turmoil began threatening Algeria’s oil production (3% of world supply) and spread to some producer of the Arabian Peninsula, then even higher oil prices could become a fact. One broker recently went so far as to project a 220 US dollar oil price. This, in our view, is somewhat far-fetched.

Nevertheless higher oil prices, should they linger longer, will certainly impact growth negatively. A rule of thumb for developed markets suggests that 10 US dollars more per barrel in the oil price shaves 0.3% to 0.5% off of headline growth depending on the country and — sometimes forgotten — the extent to which the oil price rise reflects the weakening of the US dollar. The recent strengthening of the euro and the Swiss franc against the US dollar surely mitigates the surge in oil prices.

“Higher oil prices, weaker growth, risk of stagflation: only bad economic news,” one might be inclined to say. However, for the investor there is also a brighter side to this.

In our view, one of the main risk scenarios at the beginning of 2011 was an earlier-than-anticipated reversal of the ultra-lax US monetary policy. Obviously, with growth at risk due to higher oil prices, an earlier-than-forecasted rate hike by the Federal Reserve becomes less and less likely.

That said, this bright side of the coin has its umbral partner. If the growth outlook becomes too weak, then the voices calling for new quantitative easing measures by the Fed beyond the QE2 program scheduled to run out in June will become louder.

High oil prices are caused not only by the Arabian spring; they also manifest the creation of tremendous liquidity. Hence, should the Fed consider further quantitative easing measures after QE2, then a vicious circle similar to that in the 1970s (high oil prices – lax monetary policy – even higher oil prices) could become reality. Let’s hope that this mistake is not repeated.