By Tom Fahey, Senior Global Macro Strategist

Ryan McGrail, Senior Credit Analyst

Richard Skaggs, Senior Equity Strategist

Joseph Taylor, Senior Emerging Markets Strategist

 

The market has added a substantial risk premium to the price of oil given the unrest in the Middle East and North Africa (MENA). Prices have increased by more than 20% since the beginning of December 2010; half of that increase occurred during the past three weeks in reaction to unrest spreading to Bahrain, one of the Gulf States. Market participants, generally blindsided by the events in Tunisia, Egypt and Libya, have raised their probability calculations for “black swan”(note 1) events. We think there may be excess pessimism in the market, as reflected in increased concerns about unrest spreading to the other Gulf States. We see those concerns as potentially overblown.

 

POLITICS

 

The “Big Questions” relate to Saudi Arabia, will unrest take hold in the Saudi population, lead to regime change and disrupt 12% of the world’s oil supply? Another key question is whether the other Gulf Cooperation Council (GCC) states of Bahrain, Kuwait, Oman, Qatar and the United Arab Emirates, which supply another 9% of total global production, are also vulnerable?

 

Dynamics in North Africa are Very Different from the GCC States and Saudi Arabia: Wealth inequalities and lack of economic opportunity inspired the citizens’ revolts in North Africa (Tunisia, Egypt and Libya). The region is poor and unemployed. Rapidly rising food prices and inflation in the basic costs of living may have been critical triggers for the revolts. The combination of being poor, unemployed, young and with no political voice is a potent recipe for taking protests into the streets. Algeria, another major oil producer, shares qualities with Libya, which could mean a North African risk premium in oil prices is likely to continue.

 

 

Massive Wealth in Other Gulf States Minimizes Risk: The GDP per capita of the Gulf States is materially different from North Africa’s. Furthermore, expatriates dominate the populations. In the UAE, Qatar and Kuwait, 70% to 90% of the populations are non-citizens employed in low-skilled service sectors or professionals in the finance or energy sectors who can be sent home if they cause trouble.

 

While Bahrain stands out as the GCC state that is witnessing major civil unrest, the situation there is much different in that its causes are both economic and religious. The religious dynamics help explain how Bahrain could become a flash point in the Middle East. Bahrain has a majority Shia population, but wealth and Bahrain’s governance is concentrated in the hands of the Sunni minority. There is a risk that Iran, with a majority Shia population, could reach out to the Shia majority in Bahrain in an effort to stir trouble in a key US ally that borders Saudi Arabia.

 

The GCC recognizes the risks and is negotiating a $10.4 billion support package for Bahrain.(note 2) The GCC, with an aggregate GDP of approximately $1.0 trillion, should be able to easily finance this amount. The impact could be substantial since this package represents almost 50% of Bahrain’s GDP. Therefore, we think the unrest in Bahrain can be contained.

 

Saudi Arabia is NOT a Tinderbox: The House of Saud has been the ruling family in Arabia since 1744(note 3) and has a well-established legitimacy. The government and the religious authorities closely cooperate. There is no single set of grievances by those who are advocating for change. Moreover, the changes sought are largely conservative, such as women wanting the right to drive and other cultural freedoms. The issues are not about regime change.

 

We think the Saudi government can preempt unrest by meeting many of these demands through the fiscal largesse the country announced last week. The expenditures total $36 billion (8% of GDP) and will focus on housing, education and unemployment.

 

OIL

 

Loomis Sayles estimates that the oil price includes a risk premium of approximately $15 to $20 per barrel. The premium reflects the potential for unrest in the MENA region, as well as concerns about disturbances possibly extending to Algeria or Saudi Arabia and further impacting global oil production. While this risk premium could persist for some time, we do not anticipate a major spike in oil prices from current levels that could push economies into recession. Unrest in the MENA Region Comes at a Good Time for the Oil Market:

 

• Refineries are in the midst of maintenance season.
• Global crude oil inventories are high, especially in the US where the West Texas Intermediate (WTI) crude oil price is trading at a discount to other international crude due to the high inventories in the Cushing hub in Oklahoma.
• On the whole, high global inventories and spare capacity in Saudi Arabia are helping to lower the impact of shut-in Libyan production. If the unrest in Libya had occurred during the height of oil prices in 2008, it is possible that the oil price could have risen to $200 per barrel given the lack of spare capacity at that time.
• The current oil spike is not currently translating into a full-blown energy shock largely because natural gas is oversupplied and prices remain low.
• Libya produces around 1.6 million barrels of oil per day and the International Energy Agency estimates that .85-1 million barrels of capacity is currently off line.

 

The spare capacity of OPEC and Saudi Arabia is likely to be a critical driver of potential oil price spikes. As shown in 2008 when oil prices rose to $140 per barrel, low spare capacity reduced OPEC’s ability to lower prices by increasing production, which contributed to prices rising to a point that impacted demand (see chart below).

 

 

On the positive side, OPEC’s spare capacity at 5,000,000 barrels per day (bpd) is more than double the 2,000,000 bpd level in 2008. Importantly, domestic US crude oil production increased by 3.5% in 2010 and oil inventories remain high. Therefore, we don’t expect a destabilizing spike in oil prices toward $150 per barrel that can be sustained unless OPEC’s spare capacity is significantly overestimated or another major producer such as Nigeria, Saudi Arabia or Iran cuts production due to unrest in their country.

 

INTEREST RATES AND THE US DOLLAR

 

The monetary policy response to an oil price spike is a major challenge for central banks. They must decide whether it is an inflationary shock that should be addressed through higher interest rates, or a demand shock that requires lower rates.

 

The growing macro policy divide between Europe and the US is striking. For example, the European Central Bank (ECB) is targeting headline inflation so rising oil prices have brought forward the European tightening cycle to a second quarter start compared to earlier expectations of rate hikes in late 2011. The euro has appreciated on expectations for rising interest rates. In contrast, Ben Bernanke wrote in a 1997 Brookings Institution paper “an important part of the effect of oil price shocks on the economy results not from the change in oil prices, per se, but from the resulting tightening of monetary policy.” Thus, it seems clear that the Federal Reserve may remain one of the most dovish central banks in the face of this oil shock, and the most dovish central bank historically gets the weakest currency.

 

Emerging markets central banks are already in a tightening cycle and the oil price spike reinforces that policy stance since food and energy make up more than 40% of the consumption basket in many of these countries. In fact, it could accelerate the desire of Asian and Latin American central banks to further tighten and tolerate a faster pace of currency appreciation, which is our expectation for these regions.

 

ECONOMIC RECOVERY

 

We believe oil prices will stabilize around current levels given OPEC’s significant spare capacity, high oil inventories and an oversupply of natural gas. The economic recovery is likely to stay on track, supported by an accommodative US monetary policy and the resilience of the consumer.

 

We believe US consumers will be able to adapt to moderately higher oil prices without risking a double dip recession. Energy spending as a percentage of US disposable personal income (DPI) is a little more than 5%, and has been trending down moderately over the long term.(note 4) Gasoline is approximately 3% of DPI. Based on historical relationships seen in the next chart, a hypothetical 10% increase in the price of oil could push this ratio up toward the 6% level. This would be high by recent standards, but not so high compared to the long-term history. While the last spike above 6% was associated with a recession, in our view, the sharp decline in US real estate prices and associated global banking problems were far greater contributors to the recession than higher oil prices.

 

 

We recognize, however, that some slowing of the recovery should be expected if considerably higher oil prices continue. Oil prices closer to $150 per barrel, and sustained for more than six months, would bring the economy closer to the tipping point of recession and significant credit spread widening. In isolation, oil prices at $150 could shave more than 1.0% from GDP in the US and Europe. Our estimate is that a $10 rise in oil prices would subtract 0.2% from US GDP growth, with similar results for other developed countries.

 

On the other hand, excess capacity and reduced demand can have a rapid negative impact on the price of oil.

 

CREDIT SPREADS & STOCK PRICES

 

So far, credit spreads have been immune to the rise in oil prices and we would expect that to continue as long as short-term interest rates remain very low. We believe the following factors should be favorable for credit spread stability:• Central bank policy rates in the major economies at, or close to, zero • A very steep US yield curve and easing lending standards

 

Credit spread widening could be a greater risk in Europe. First, Europe is more directly impacted from the supply disruptions in North Africa. Second, the ECB has signaled it is embarking on a tightening cycle in 2011. Finally, we forecast European GDP growth will only be 1.6% in 2011, which leaves less room for negative shocks.

 

Stock prices, as well as US credit spreads, should benefit from healthy corporate profit margins, relatively easy access to financing and a weak US dollar. However, the risk premium in the price of oil has contributed to a consolidation(note 5) and higher short-term equity market volatility, as measured by the VIX.(note 6) After experiencing a powerful rally, propelled by robust corporate profits in the fourth quarter of 2010 and S&P 500 earnings that were up more than 25% year-over-year, stocks were overdue for a pause or pullback. We see earnings growth likely moderating as earnings normalize to a sustainable growth rate, perhaps in the 8%-10% range, comparable to long-term averages in business expansions. In our opinion, the S&P 500 remains attractively valued at roughly 13.2 times(note 7) estimated 2011 earnings as compiled by Standard and Poor’s Corp.

 

SUMMARY

 

• We don’t expect citizen revolts to spread beyond North Africa to Saudi Arabia or other parts of the GCC.
• Oil prices should stabilize around current levels as OPEC’s spare capacity and oil inventories are both high.
• While a major oil price spike could come on the back of revelations that OPEC’s spare capacity is overstated, that is not our core view.
• This is not currently a major energy crunch because natural gas prices remain low, and this should alleviate fears of a major economic drag.
• The Federal Reserve will likely remain the most dovish central bank in our view, which could help to keep the US dollar weak.
• Credit spreads can sustain some volatility but should remain firm as leading indicators of the credit cycle are still favorable despite the rise in oil prices.
• Multiple factors in the equity market continue to support valuations: earnings revisions remain positive, announcements of share repurchases and dividend increases have been on the rise, mergers & acquisition activity has been picking up and interest rates remain low.

 

Notes:

 

1 Black Swans were described by Nassim Nicholas Taleb in his 2007 book, The Black Swan. He used the Black Swan Theory to explain the existence and occurrence of high-impact, hard-to-predict and rare events that are beyond the realm of normal expectations.5 The S&P 500 closed at 1,273.72 on Thursday, March 17, 2011, down about 5.3% from its multi-year-recovery high 2/18/11.

2 Source: Associated Press.

3 Source: Wikipedia.

4 Source: Bureau of Economic Analysis.

6 The VIX is a volatility index used in the United States to illustrate short-term expected stock price volatility.

7 As of March 17, 2011.

 

This report is provided for informational purposes only and should not be construed as investment advice. Any opinions or forecasts contained herein reflect the subjective judgments and assumptions of the authors only and do not necessarily reflect the views of Loomis, Sayles & Company, L.P., or any portfolio manager. Investment recommendations may be inconsistent with these opinions. There can be no assurance that developments will transpire as forecasted and actual results will be different. Data and analysis does not represent the actual or expected future performance of any investment product. We believe the information, including that obtained from outside sources, to be correct, but we cannot guarantee its accuracy. The information is subject to change at any time without notice.

 

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