Ferment in the Global Oil Markets and Spillover Risk

By John Longo, Professor of Finance & Economics

Summary: The rise in oil and other commodity prices threatens to derail the global economic recovery.  Although 2011 is likely to be a good year for the equity markets due to the unattractive risk profile of fixed income investments, our longer term problems of excessive debt, high unemployment, higher taxes, and rising inflation and interest rates cannot be ignored.  Continued turmoil in the commodity markets may spillover to the economic fundamentals and push the global economy back into the “new normal.”

The disruption of oil production in Libya puts pressure on global supplies at a time when demand is increasing due to an improving, but still fragile global economy.  While Libya has been named as 12th among global oil exporters, concerns are mounting that its political and social unrest will spread to adjacent nations and possibly even to a major supplier, such as Saudi Arabia.

Recent prices have reached record highs of over $107 per barrel, surges that have a ripple effect throughout the supply chain for a host of goods and services. Commodity prices are not only driven by fundamentals, but also by speculation and U.S. Federal Reserve monetary policy.   For example, cotton is at a two-year high, wheat prices are up 60 percent and corn (a major ingredient for biofuels), has risen 93 percent since last year.  Fortunately, rice, a staple that nourishes a major sector of the world’s population, has seen an increase of less than 4 percent.  If rice prices were to surge, social unrest may accelerate further thoughout the globe.  Since commodities around the world are priced in U.S. Dollars, Federal Reserve policy that may weaken the dollar results in increases in commodity prices.

The rise in commodity prices is felt to a greater extent by middle and lower income households since food and energy prices comprise a larger share of their expenditures than is indicated in the broad CPI Index. People are cutting back on driving, turning the thermostat down; often choosing fuel for the home furnace over gas in the car.  There’s a renewed interest in compact, budget-saving vehicles.   Swapping landline phones for a cell phones has become commonplace, but consumers are increasingly foregoing cable TV in favor of entertainment on the Internet.  Netflix is one prime beneficiary of this trend, rising nearly 10 fold in less than three years. 

Compensating for our oil consumption with alternative energy sources is not a feasible option in the short-run, since many biofuels are simply not economically viable at this time.  Coal we have in abundance, but it is environmentally unfriendly.  Senator Jeff Bingaman, among others, are calling upon the federal government to tap the nation’s strategic petroleum reserve, which is now at full capacity of 727 million barrels.  This may temporarily halt the surge in energy prices, at least until the summer driving season arrives.

The equity market continues to be robust primarily due to fund flows, and to a lesser extent improving economic fundamentals.  Cash is yielding close to zero and market psychology and fund flows have turned negative on bonds funds.  When combined with the traditional bullish 3rd year of the Presidential election cycle, equities are the primarily beneficiary of capital flows over the near term.  However, there is a limit to the ability of the economy to absorb the continued surge in oil and other commodity prices, especially with a backdrop of high global unemployment and increasing social unrest.  Although 2011 is likely to be a good year for the equity markets, our longer term problems of excessive debt, high unemployment, higher taxes, and rising inflation and interest rates cannot be ignored.  Continued turmoil in the commodity markets may spillover to the economic fundamentals and push the global economy back into the “new normal.”