Libya: impact on oil, economy?

 

Libya: impact on oil, economy?

BY Fidelity's Market Analysis, Research and Education Group (MARE), Fidelity Viewpoints — 03/02/11

Our experts believe the global economic recovery is not yet in jeopardy.

The North African countries that have undergone the greatest political unrest so far—Libya, Egypt, and Tunisia—collectively account for only a miniscule slice of the global capital markets and economy. However, ongoing developments in the region can affect the global financial markets in a variety of ways, particularly through their influence on crude oil prices and the geopolitical risk premium for financial assets.

Oil prices and supply/demand imbalances

While turmoil in Tunisia and Egypt put upward pressure on global crude oil prices, the negligible petroleum production from those countries meant there was little impact on the global supply/demand balance for crude oil. However, Libya accounts for roughly 2% of global oil production and 3% of global oil exports.¹ With reports that significant amounts of Libya’s production have gone off-line, there is likely some fundamental impact from the region’s unrest on the global economy.
Losing Libya’s production from the global crude oil markets, however, is not likely to be a traumatic event because the world is reasonably well supplied with oil and has some supply cushions that could help prevent near-term disruptions of this magnitude. Crude oil inventories held by the 34 countries that are members of the Organization for Economic Co-operation and Development (OECD) are at above average levels, with nearly 58 days of supply on hand versus an average of 53 days from 2005 to 2008.² Spare production capacity, primarily in Saudi Arabia, is estimated to be more than twice the size of total Libyan production, and Saudi Arabia has already brought a portion of this online. In addition, several countries, including the United States, maintain strategic petroleum reserves that could be utilized as well.
From a fundamental supply/demand standpoint, the outlook for higher crude oil prices in 2011 was already expected, with prices having moved up 12% in the fourth quarter of 2010 largely because of the strengthening U.S. and global economies.³ However, the majority of the increase in crude oil prices in recent weeks has been due to an increased “risk premium” for the commodity, which reflects the possibility of political unrest spreading to additional and particularly larger crude oil producers in the region.
Since Egypt’s “Day of Rage” on Jan. 25, 2011, the per-barrel price of U.S. crude oil has risen to almost $98, from $85, while European crude oil prices spiked above $110, from $96.⁴ If any additional producers from the Organization of the Petroleum Exporting Countries (OPEC), such as Saudi Arabia and Iran—which together account for roughly 20% of global exports—were to experience supply disruptions, it could cause a far greater spike in crude oil prices (see the table below.) Read Viewpoints: Rising oil prices and energy stocks for further commentary on the energy sector from John Dowd, portfolio manager of Select Energy Portfolio (FSNEX) and Select Natural Resources Portfolio (FNRAX) .

Perspective on rising geopolitical risk and the threat to riskier financial assets

Stock and bond markets in the Middle East and North Africa are small by global standards, but the potential for the spread of political instability can have an impact on the risk premium for financial assets around the world. So far, the biggest impact on performance has been to securities in countries most directly affected, with Egypt’s stock market down about 20% in 2011 before it was suspended in late January, and the prices of its dollar-denominated government bonds declining about 10%.⁵ Emerging-market assets as a category have gotten off to a choppy start in 2011, though much of this can also be attributed to inflation pressures and other investor concerns that were apparent before the recent political turmoil. The longer the political upheaval lasts and the farther it spreads, the more potential it has to increase risk aversion and act as a headwind for emerging-market stocks and other assets. So far, the detectable damage has not been extensive.
More broadly, the political and economic uncertainty has the potential to act as a headwind for riskier assets. The week ending February 25 featured the largest negative returns of any calendar week for the U.S. stock market in 2011. However, the 1.7% loss to the S&P 500^® Index was a relatively minor pullback in the context of the 16.6% rise during the past five months. While safe haven assets such as Treasury bonds and gold rose, whether risk aversion continues to increase will likely depend significantly on whether the events in the Middle East pick up steam or begin to stabilize.⁶

Outlook on contagion, crude oil prices, and the global economic recovery

The potential for political upheaval to spread to other crude oil-producing nations is inherently unpredictable and unquantifiable. The countries that have experienced unrest so far have shared a few common traits, some of which are held in common with other oil-producing countries in the Middle East. These include high levels of unemployment and poverty, a population with a high percentage of young adults, and leaders who have exercised power for decades with regimes widely recognized for corruption and repression. However, even the largely non-violent spontaneous demonstrations in Egypt look very different from the armed conflict in Libya. So while many key oil-producing countries, from Algeria to Iran to Saudi Arabia, have something in common with these economic and political backdrops, they all have dramatic differences in key areas that may make them less vulnerable to civil strife.
Ultimately, the most direct and lasting impact on global financial markets would be if higher crude oil prices change the trajectory of the economy. On the one hand, the more than 150% oil price increase since February 2009 is the kind of abrupt, short-term spike that historically has often precipitated a recession in the United States.⁷ Higher crude oil prices act as a tax on consumer spending and business operations, taking money away from consumer discretionary purchases and squeezing corporate profit margins.
On the other hand, the U.S. economy is much better positioned to weather crude oil prices settling above $100 per barrel than during mid-2008, when petroleum prices hit record levels amid a U.S. recession. The U.S. economy re-accelerated in the second half of 2010, and recent strength in leading economic indicators suggests a continued broadening of the expansion. Though crude oil prices are up sharply from the $34 per barrel daily low set in February 2009, consumers have already experienced $100 per barrel oil before, and the brief revisiting of sub-$50 oil prices in 2009 probably did not change the expectation that crude oil prices would move higher over time.⁷
From a global standpoint, if oil remains at about $100 per barrel in 2011, oil expenditures would represent about 5% of global economic activity. Given the continued strong growth in developing economies and solid global expansion overall, this level appears to be manageable. If crude oil increases to $120 per barrel and stays at that level, oil expenditures would increase to 6% of global GDP—a level not seen since the early 1980s.⁸ Above this price level, pressures on consumers and businesses would probably increase substantially.

Investment implications

While political weakness in the region and the probability of higher crude oil prices in 2011 were not surprises, the speed of political upheaval and the uncertainty about the political outlook have increased the risk more generally in the global financial markets. To this point, however, the positive momentum in the United States and global economic expansions has not been derailed. We will continue to monitor the situation in the Middle East and North Africa, with particular attention to the ability of recent developments to influence the world oil markets and geopolitical risk premiums.

How we’re monitoring developments in the Middle East and North Africa

Our portfolio managers gauge the potential direct and derivative impacts of geopolitical risk by tapping a broad array of research and analysis from our experts in the region, energy sector analysts, and other global investment professionals.
From a geopolitical perspective, our sovereign debt team provides scenario analysis concerning risk, outcomes, historic similarities and important differences to evaluate the contagion risk.
From an economic perspective, we gauge the impact of potentially higher crude oil prices and the possibility of negative impact on global growth. We evaluate this risk primarily at the company level; for example, by analyzing whether the industry is highly sensitive to a global slowdown, how much risk is priced in, the downside protection of current valuations, whether earnings expectations are reasonable, and whether the company’s customers or costs are highly influenced by changes in crude oil prices.
With respect to potential investment opportunities in the Middle East and North Africa region, the weak political systems in many countries had led us to place very high risk premiums on many of the equity opportunities before the recent upheaval. It is possible that a structural change may be taking place that could ultimately be positive for the investment climate in the Middle East and North Africa, but it will take time to sort out the long-term political trends given current uncertainties.