Shock waves from oil on troubled waters

Parallels with the past suggest turmoil within the Mena region triggers economic upheaval across the rest of the world. Times may have changed but risks remain.

Brent crude rose back close to two-and-a-half year highs on Wednesday as Libya warned of higher oil prices due to the crisis and its government forces fought rebels in the oil-rich east. REUTERS/Eric Show more

With Hosni Mubarak gone, overthrown by a display of people power, autocratic leaders across the Mena region are shaking in their boots. Little wonder. The region provides more than 35 per cent of the world's oil, which has already breached US$100 a barrel.

The question is: what's next in store for oil prices? As was previously the case during the two Gulf wars, the answer depends on politics. The uncertain political scenario has thrown fundamental analysis of supply and demand out of the window.

So far, the prices have not been pushed up by actual supply disruptions. Oil peaked even before the news that some foreign oil companies operating in Libya will cut production

Oil markets don't like surprises. The sudden ousting of Mr Mubarak as president of Egypt and the unrest in Yemen, Bahrain, Oman, Libya, Iran and Algeria, which together accounts for 10 per cent of the world's oil supply, have led to an increase in oil prices. The big worry is that this contagion will lead to another oil shock similar to that of the Iranian uprising.

Oil is more global than it was previously. In the 1970s, production was concentrated around the Gulf. Since then, non-Opec markets have emerged from Latin America, West Africa and Russia. Russia overtook Saudi Arabia as the world's biggest crude supplier in 2009; Opec's share of production has declined from about 50 per cent in the mid-1970s to just over 40 per cent.

Yet the clout of Opec has not diminished because it is still the largest exporter of crude. Markets are tight at the moment. High inventories built up during the downturn are running down as the developed world recovers and Asia continues its growth spurt.

If Libya's oil stops, importers will look to Saudi Arabia to make up the shortfall. Despite its assurance that it stands ready to produce more oil, the kingdom has so far been reluctant to turn on its tap.

Any kind of disruption to Saudi Arabian supply would be a worst-case scenario for oil prices. This concern is made relevant in light of the unrest in neighbouring Bahrain.

Although this tiny island produces little oil, it is vital to keep the supply uninterrupted, as its seaway carries 18 per cent of the world's oil.

The history of the oil market has been marked by Middle Eastern crises, in addition to recession and supply shocks. To gauge this risk we need to answer some tough questions. How vulnerable is the oil market to an interruption in supply? How sensitive is the world economy to oil price increases? And how do the policymakers cope with a shock if the worst scenario happens?

The troubles in Libya are one such serious example of the impact of Arab unrest on global oil markets. Prices jumped as Egypt's citizens took to the streets. Even though Egypt is an oil importer, its Suez Canal is a vital conduit between the huge oilfields in the Gulf and markets in Europe.

The IMF reckons that a 10 per cent increase in the price of crude shaves 0.2 per cent to 0.3 per cent off the global GDP in one year. Oil prices are about 10 per cent more costly than the IMF assumed in late January, when it projected global growth of 4.4 per cent this year. That implies the IMF foresees growth of about 4.2 per cent.

The rich world seems to be less vulnerable to oil shocks, as it has substantially reduced the amount of oil used per unit of output. The US economy is twice as large in real terms as it was in 1980. Yet over that period American oil consumption rose only slightly from 17.4 million barrels per day to 17.8 million.

Europe actually used less oil in 2009 than in 1980, even though its economy had grown. Emerging economies may be hit harder by a price increase, since they use more oil per unit of output than rich countries.

The world could probably weather a short-lived crisis. But the damage if oil prices were raised and stayed high for a long period of time could be costly for the recovering economies of the western world.

It would be gravely erroneous for the rest of the world to underestimate the importance of the Middle East when it comes to global oil supplies. Strong Asian demand means Opec's share of oil production rises again as it pumps extra output eastward.

A troubled region's capacity to cause trouble cannot be written off. With protests spreading across Arabia, is the world in for another oil shock? The 1970s oil shocks transformed the world economy. Perhaps an oil shock this year might do the same.

Walid Hayeck is the head of asset management at The National Investor