- The recent increase in prices is likely driven by fear of supply disruptions and not because of optimism about economic growth.
- Consumers and businesses are probably more resilient to oil and gasoline price increases than they were in 2008.
- The oil price increases are likely to influence the near-term earnings outlook more than the long-term growth outlook.
- There are a number of factors that can offset short-term supply disruptions, like increased output from Saudi Arabia and tapping the U.S. Strategic Petroleum Reserve.
Whether West Texas Intermediate (WTI) or Brent crude, oil prices have been increasing for a variety of reasons. The benign reason is because the global economy is still growing and emerging markets are pursuing expansionary monetary policies, resulting in increased demand for oil. But the more dangerous reason is that the Iranian government is growing increasingly hostile toward Israel and its allies.
Clearly, this situation bears monitoring. Most important, there is the threat of the loss of many lives if there is a conflict. Secondarily, higher oil prices can present problems for economic growth and the markets even without a conflict.
Iran is the fourth-largest exporter of oil in the world. The U.S. and other countries have been opposed to the Iranian pursuit of developing nuclear capabilities. The Iranian government has refused to allow some United Nations inspectors from visiting some Iranian sites, which suggests Iran has progressed in developing its uranium-enrichment capabilities.
To punish Iran for pursuing a nuclear weapons program, the European Union (E.U.) went along with the U.S. in imposing sanctions against Iran. On January 23, the E.U. announced it would ban crude oil imports from Iran, beginning July 1 (it wants time to find alternative supplies). On February 20, Iran announced it would immediately stop selling oil to France and Britain. The Iranian government has also threatened to close the Strait of Hormuz—through which approximately 15.5 million barrels of oil travel every day, which is about one-third of the world’s seaborne shipments. Iran also recently sent war ships through the Suez Canal into the Mediterranean and positioned them uncomfortably close to Israel. The situation is eerily similar to events surrounding the Yom Kippur War in 1973 between Israel and a number of Middle Eastern countries. During that time, Egypt shut down the Suez Canal, the U.S. sided with Israel, and the Arab members of OPEC banned exports of oil to the U.S., all contributing to oil prices spiking.
However, today’s situation is quite different from 1973. Perhaps the most important difference is that Iran may be more isolated in its efforts than it was in 1973, which could limit the rise in oil prices and the duration of any conflict. Higher prices threaten to sap more purchasing power from consumers as they continue to struggle with wages growing slower than consumer prices. While higher prices can benefit certain sectors—especially the energy sector—they can be a drag on earnings in most other sectors.
In July 2008, oil prices reached a record high, resulting in a change in consumer behavior. Americans began to drive less and replace gas guzzlers with more fuel-efficient vehicles, and businesses responded as well by increasing efficiency. The previous spike in prices has a long life, which can make consumers and businesses more resilient to any subsequent increase in prices. In other words, it’s not just the level of oil or gasoline prices that matters, but the level relative to the previous peak.
The likely effect of higher oil prices on stocks is somewhat indirect, working through investors’ expectations for near-term earnings and longer-term growth. I looked at data on Brent Crude prices—both the level of the price and the level relative to the trailing four-year maximum price—and found that the most significant effect is likely to bring down investors’ expectations for the near-term earnings outlook. As of February 24, according to FactSet Research, the consensus forecast for earnings in the S&P 500 Index over the next 12 months is $107.22 per share. With Brent crude at $123.86, which is 85% of the previous peak, the consensus expectation for earnings over the next 12 months could come down to $102.76 per share. The long-term growth rate is likely to stay relatively unchanged. The reduction in near-term earnings expectations could translate into a 4% decline in the S&P 500 Index to around 1,310. If oil prices rise even higher, say to $150 per barrel, it could translate into an S&P 500 Index level of around 1,280. It’s important to remember, though, that markets tend to overreact, especially if there is a conflict associated with the increase in prices.
While I think there is already a tremendous risk premium (a fear factor) priced into oil, prices can still go higher. But there are some forces that could counteract a rise in prices. Saudi Arabia has already stepped up oil exports, and the U.S. has a Strategic Petroleum Reserve (SPR) that could be tapped. As of the end of January, the SPR had 695.9 million barrels of oil, which is approximately 40 days’ worth of total oil consumption in the U.S. However, even though the U.S. consumes more than 17 million barrels per day, it only imports 9.163 million barrels per day, 4.885 million barrels of which come from OPEC-member nations. That means that the U.S. has nearly 142 days’ worth of oil in the SPR if all OPEC sources were cut off. Iran is a member of OPEC, but it might stand alone in a boycott.
High oil prices are likely driven mainly by the fear coming from recent events in Iran. If there is a disruption in the oil supply, it should be relatively short-lived, although it could put stocks under pressure.