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Oil price: the likely negative effects

By Mthuli Ncube

WHILE the global economy and airline industry had recovered from the negative-wealth effects of September 11 events and subsequent military action in the Middle East, the oil price has become

the latest worry for continued strong growth prospects for the world economy going forward.

Needless to say the worst to be affected are the developing countries that are non-oil producing.

In the week ending October 9 the crude oil price had risen to the US$52 per barrel zone, in New York. However, this price level is still lower than the inflation-adjusted price of around US$80 per barrel seen in the late 70s and early 80s period which resulted in double-digit inflation in the US and around the world.

The current price is close to the US$54 adjusted for inflation, when Iran invaded Kuwait in August 1990. It looks like the oil price may not fall below US$40 per barrel before the end of 2005, and may remain above US$35 for the next two to three years, a worrying prospect.

What are the reasons behind the recent oil price hike? There are both supply and demand reasons, which have worked in a concerted effort to push oil prices higher. On the supply side, the hurricane that swept through the Caribbean region and fringes of the US interrupted supply from offshore producers in the Gulf of Mexico. The initial supply disruptions triggered by the Coalition-led invasion of Iraq, seem to have been stabilised by Opec’s compensatory increases in supply, but nevertheless also contributed to the oil supply constraints. Opec output is already at its highest in 25 years and capacity outside Opec is limited.

One other reason for the hike in the oil price pertains to the labour strike in Nigeria which is causing work stoppages in the oil sector resulting in lower oil output from Nigeria. It is not obvious when the strike will be resolved.

Nigeria is also facing armed rebel activity in the oil producing zones. The rebels are targeting international oil producing companies in their desire to be heard with regards to oil production in Nigeria. Again, it is not obvious how the rebel action is being resolved and whether it could escalate further before it is brought under control. This is yet another reason which is fuelling uncertainty in the normalisation of oil supplies globally.

Another supply side factor pertains to the action that has been taken against the oil company Yukos by the Russian authorities. Yukos accounts for a significant amount of oil production in Russia. The tax liability that is being brought against it by the authorities has brought it to the brink of bankruptcy. The markets have factored the Yukos affair as a supply constraint contributing to the hike in the oil price.

There are also various demand factors that are working in concert with the supply factors above. First, the winter season is now approaching in the northern hemisphere. Winter typically results in higher oil consumption in the heating-oil segment. The higher demand for heating-oil is helping prop up the oil price. Secondly, Asia is still experiencing high economic growth resulting in high demand for oil and its products, especially China. China’s thirsty economy continues to accelerate and is now responsible for about 8% of the world’s petroleum production. In the first half of 2004 China’s demand for oil grew by 21%, while that of the US only grew by 3,5%. The growth in oil demand by the whole world was only 2,3% last year.

China will continue to show very strong growth in the years ahead.

What are the potential economic effects of the rising oil price? The high oil price will lead to lower growth and higher inflation globally. Preliminary international research shows that whenever the oil price rises by US$5, US and European economic growth falls by 0,4% and inflation rises by 0,3%.

The corollary of higher inflation is tighter monetary policy in the form of higher interest rates going forward. Higher interest rates will have an additional effect of raising the cost of capital and slowing down investment and consumption.

Also, higher interest rates in the US may strengthen the US dollar, further widening the current account deficit, thus buttressing the slow growth pattern in the US economy. Generally, the world economy seems to be moving towards slower growth as a result of the oil price hike.

What does this mean for global investors in international markets? The rising oil price is positive for oil stocks which investors should hold in their investment portfolios. Already we have seen stocks like BP performing well on the international stock markets. Investors should also invest in gold stocks, gold funds or buy bullion generally because the gold price is set to rise further.

The gold price has already hit the US$420 level. Gold is playing its traditional role as a safety haven and inflation-hedge for investors. Investors should avoid investing in passenger-airline stocks because fuel expenses typically amount to at least 35% of total operating costs of an airline. The rising oil price will therefore hurt airline companies.

Bond markets typically move negatively to the inflation trend. As world inflation continues to increase, the bond markets will decline and investors should be wary of this. Once the bond market falls the equity market will also begin a downward trend except for the oil stocks. Equities will also become a risky asset class going forward.

However, because of tighter monetary policy going forward, the money (cash) market will become attractive as well. Cash will be king.

Emerging markets such as Zimbabwe will be affected negatively by this hike in the oil price, as is the case with many other emerging economies.

*Mthuli Ncube was former head of Barbican Bank.

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