With rising oil prices and rates, we are at last returning to normality
For financial markets, the new year has got off to an unsettling start. Government bond yields have risen sharply, and so too has the oil price, leading some commentators to declare that we are at a new inflection point, with trouble ahead in markets and the economy. Is this just another, midcyclical squall, of the type we have seen several times before in the current recovery phase, or does it presage something more fundamental and therefore worrying?
Start with oil. All of a sudden, more or less everyone has turned bullish on the world economy; demand is rising at a time when Opec, to almost universal surprise, has been relatively successful at keeping the lid on production. The other big factor underpinning a higher oil price is something I’ve written about before – the return of a geo-political risk premium, traditionally thought to be worth something like $10 a barrel on the price. This all but disappeared in the excitement over burgeoning US shale production, which has made the world less reliant on supply from politically unstable parts of the world. But now it’s coming back.
Popular protest in Iran might embolden Saudi Arabia, now backed to the hilt by an seemingly bellicoseminded US president, into doing something really silly in the region. What’s more, the US has been threatening new sanctions against Iran, which if implemented could again partially freeze Iran out of global markets. There is also a big question mark over production from Venezuela and Nigeria. Analysts may, however, once again be underestimating the impact of shale, which with a recovering oil price is back to a “drill, baby, drill” mentality. US shale investment, having been halted by the collapse in oil prices, is coming back, with US production soon likely to surpass the 10m barrels a day mark. This phenomenon – that once the oil price gets past the shale break even point of around $55 a barrel, production comes flooding back – puts a natural ceiling on the price, making it most unlikely that oil will get back to past peaks, even with a fast growing world economy.
Add to that the burgeoning number of speculative positions that will shortly be looking to bank profits, and it may well be that oil uber bulls are again about to be disappointed. That would be my bet. Remember, oil still has the power to shock; if the price rises too far too fast, it could, by eating into consumer spending, upset the global expansion and tip the economy into recession. All too frequently, it’s happened in the past. At this stage, however, the rise is not big enough to bring the cycle to an end, nor does it seem likely it will become so.
Some of the same observations can be made about the correction in bond markets, and the consequent rise in market interest rates. Primarily, this is about a “normalising” world economy, with investors rediscovering their appetite for risk. It’s also about the withdrawal of central bank monetary support. So far the US Federal Reserve has managed this reversal well. Others may not be quite so sure footed. When central banks talk about engineering a “soft landing”, they mean tightening policy sufficiently to allow for a safe descent, but not so fast it generates a stall. Often they get it wrong.
The risks are heightened by a world economy stuffed to the gunnels with debt. We’ll see. Yet as with the oil price, it is very hard to see interest rates rising back even to relatively tame pre-crisis levels, let alone the elevated peaks of the past.
Disinflationary forces in the world economy are still too strong. It’s always right for investors to worry; but it’s still too early to call an end to the current chapter of global growth. What we are seeing in markets is not so much the seeds of destruction as returning normality.
‘Risks are heightened by a world economy stuffed to the gunnels with debt’
A pump at a fracking site in San Joaquin Valley in California. America is said to have renewed its ‘drill, baby, drill’ mentality