A Crude Put?

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Arguably the rise in oil prices pose a new threat to the world economy. If oil prices stay elevated, it risks a policy response. Strategic reserves could be tapped as they were last year in a coordinated fashion. In addition, the risks of a new round of Federal Reserve asset purchases would seem to increase with the price of oil. Bernanke delivers his semi-annual testimony later this week and will likely get peppered with questions along these lines. It is possible that the rise in oil prices serves as a new form of the so-called Bernanke [Greenspan] put.

The first important point about the rise in oil prices is that there has been a genuine supply shock. Between Sudan, Yemen and Syria, nearly 750k barrels per day(bpd) have been taken out of production due to political instability. On top of this, Libyan oil output is about 600k bpd below pre-civil war levels.

In addition, the Iranian confrontation and its response (to cut sales to the UK and France) has also taken supply out of the market. The bellicose rhetoric and fear of an escalation raises the risk premium as well.

There are other, less significant,  supply disruptions. Aging infrastructure has seen North Sea output decline. Venezuela output is also lower.

There is also a role for increased demand. Japan, for example, is replacing some of its nuclear energy with oil. Its oil imports appear to be running about twice pre-tsunami levels. In addition, there has been some pick-up in demand from Asia.

Note that the IEA forecasts oil consumption to rise 830k bpd this year after a 740k bpd increase last year. The unusually cold European winter is also thought to be boosting demand.

In the US the oil shock is compounded with a spike in gasoline prices especially in the northeast. Gasoline prices may have risen simply on the back of the increase in oil prices, but there is more. In February two refiners outside Philadelphia, which account for 20% of the gasoline produced in the northeast, shutdown. Since December, US refineries accounting for 4% of the capacity have been shut down, according the oil analyst at Oppenheimer.

The loss of refining capacity appears to rival the impact of Hurricane Katrina. Yet gasoline inventories cover about 28 days of use, which is the upper end of the decade old range. Gasoline demand in the US is near 15-year lows.

Part of the problem for observers and investors is that the gasoline market in the US is not homogeneous. Gasoline prices are considerably more constrained in the midwest than the east coast. The northeast refines more expensive Brent and this is what has been taken off line. The refiners were facing a substantial squeeze on margins, unable to pass on increased crude prices. In contrast, the midwest refines cheaper WTI.

Nevertheless, investors are well aware that most of the US recessions (10 of past 11) were preceded by a surge in oil prices. Even though the US economy strengthened in H2 11 and weekly initial jobless claims (4-week average to smooth out some of the volatility) stands at new cyclical lows, Fed officials and investors recognize the vulnerability of the economy. Several members of the Board of Governors and some regional Fed presidents continue to appear sympathetic to another round of asset purchases.

We have previously argued that the bar was high for new asset purchases in that it required either increased risk of deflation and/or new threats to growth. A sustained rise in oil prices could meet the latter criteria. Given these linkages, a further rise in oil prices may be seen as dollar negative.