The Most Serious Risk to the Recovery: Oil Prices
BlackRock iShares Blog
By Russ Koesterich
June 23, 2011
While we believe the recent economic slowdown represents a decelerationrather than a reversal of the global recovery, there are certain events that we believe could turn the current fragile recovery into a failed one.
In particular, we believe investors should pay careful attention to events in the Middle East. Why? As we hinted in a recent video post, we believe that the most serious risk to the global economy is another spike in energy prices.
While the events that began in Tunisia earlier this year were both unexpected and unprecedented, the world is now aware of the political fragility of large parts of the Middle East. If there is no further geopolitical contagion there, oil prices should stabilize and arguably correct a bit. However, should further political instability endanger production in any of the key OPEC producing countries (Saudi Arabia, Iran, Iraq and Nigeria), OPEC’s remaining spare capacity could be impacted and a second oil spike could result.
Although oil prices have already spiked, the price rise to date has largely been a function of a geopolitical risk premium rather than any real supply disruptions. Thus far the only major oil producing country in which production has been significantly disrupted is Libya. So far OPEC has been able to cushion this production loss with an ample supply of spare capacity.
While OPEC came into 2011 with a healthy amount of unused capacity, even for OPEC, spare capacity is not infinite. Should another large oil producing country lose part or all of its production, OPEC’s spare capacity is unlikely to be sufficient to prevent a significant spike in oil prices. In particular, investors will want to watch Iraq, Iran and Nigeria, which each produce two million barrels or more per day. In addition, obviously any disruption within Saudi Arabia, the largest producer and the one with most of the swing capacity, would be catastrophic.
Some analysts have argued that even in the event of another spike in oil, the impact is likely to be muted given increasing energy efficiency in the developed world. We do not share this view.
It is true that over the very long term, energy-related spending as a percentage of overall consumption has dropped. However, if you focus on gasoline sales, the story looks very different. Today, the percentage of overall consumption going to gasoline is close to its 2008 peak. As of April, spending at gas stations represented nearly 12% of overall retail sales, well above the long-term average of 8.2% and the highest percentage since September 2008.
To the extent individuals are spending more on gasoline, they are likely to spend less on discretionary purchases. If oil rises, it will create another headwind for an already fragile consumer and raise the risks of a significant drop in consumption and an economic slowdown. Our best understanding of the geopolitical landscape suggests that a scenario resulting in another oil price spike is not the likely outcome, but given the unpredictable nature of events in the Middle East, the region still bears watching and has added more risk to the downside in our outlook. In fact, we do believe a double dip is more likely than it was six months ago.
Above all, we have moderated our views on future growth and are now adopting a more defensive posture through favoring sectors such as healthcare and telecommunications and through favoring mega caps in the US and developed markets. You can read more about our outlook for the remainder of the year in our latest Market Perspectives piece, the mid-year update to our 2011 Outlook.
In addition to the normal risks associated with investing, narrowly focused investments typically exhibit higher volatility. Healthcare companies are subject to extensive government regulation and their profitability can be affected by restrictions on government reimbursement for medical expenses, rising costs of medical products and services, pricing pressure and malpractice or other litigation. Telecommunications companies may be subject to severe competition and product obsolescence.
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