Francisco Blanch, head of global commodities research, Banc of America Securities-Merrill Lynch, pens his thoughts on the post-recession cycle for oil. This analysis is taken from the BAS-ML Commodities – Global Energy Weekly: Oil and Money report.
Money supply soared before the crisis, and is rising again.
For decades, the expansion of global oil consumption closely followed the expansion in global economic activity and global money supply. This relationship between the economy, oil and money started to change in 2005, due to serious physical oil supply bottlenecks. Unlike oil, however, the supply of money and credit grew unconstrained as the global economy expanded. Now, as economic activity recovers, demand for most goods will pick up, including oil and money.
A 1% increase in money brings a 1% increase in oil demand
As oil demand starts to increase again, so will prices. Looking only at the narrowest definition of money for the top oil consumers, we estimate that a 1% increase in money supply translates into a 1% increase in oil demand four quarters later. Many countries now experiencing large monetary expansions have a large share of their population in the $5,000 to $20,000 per capita income band, a sweet spot for energy demand. But just as oil prices were an underappreciated cause of the global recession, we believe that the collapse in oil prices has been an underappreciated source of stimulus. Rising oil prices will take it away.
Emerging markets central banks matter most to oil prices
If oil prices go up, the choice for central banks will be to throw OECD economies back into recession or to let headline inflation trend higher. What will happen next? This recovery is ultimately about a sustained expansion of domestic demand in emerging markets (EM). Thus, EM central bank responses matter more to oil prices than US Fed policy. The BAS-ML economics team believes that severe monetary policy tightening in EMs like China is unlikely near-term. Inevitably, the gap between money and oil supply will grow again. In due course, too much money will again be chasing too few barrels. We stick to our 4Q10 WTI forecast of $82/bbl.
In turn, the monetary expansion will create an energy intensive recovery…
Of course, an expansion in money supply is not enough to create growth in credit. In fully-fledged market economies, central banks control the money supply while the supply of credit is controlled by banks and the shadow banking system. In market economies, governments do not generally lend out directly to the private nonfinancial sector and rely instead on financial institutions to allocate capital efficiently among market participants. This is the reason why credit to non-financial institutions has started to expand again in recent months, particularly in some EMs where the government controls both the supply of money and credit. As global economic activity recovers, demand for most goods in the economy will pick up again, including oil and money. In our view, this expansion in credit will sooner or later translate into higher oil demand. Even looking only at the narrowest definition of money for the top oil consumers, we estimate that a 1% increase in money supply translates into a 1% increase in oil demand four quarters later.
The negative impact of high oil prices will be small in EMs…
In the same way that high oil prices were an underappreciated cause of the global recession, we also think that the collapse in oil prices has been an underappreciated source of consumer stimulus. The reduction in prices from peak to current levels represents a large increase in disposable income for top oil consumers. As oil prices recover, this stimulus will be taken away, largely offsetting the fiscal stimuli put in place by many countries. Yet, EM currencies will likely appreciate relative to the US$ as the global economy strengthens, partially offsetting the negative effect of rising oil prices. Moreover, with the government capping retail petroleum product prices in many EMs like China and India, the final consumer in many EM countries should be partly shielded from rising oil prices.
…but will squeeze disposable income in OECD economies
For consumers in the developed world, there is nowhere to hide. Higher oil prices could negatively impact terms of
trade and partially offset the positive impact of lower imports on GDP growth. Moreover, higher oil prices will act as an important drain on disposable income for most of the developed world. Near-term, we do not believe oil prices will move sustainably above $80/bbl, a level that our economists believe could put the economic recovery in OECD countries in jeopardy. But a trend of rising oil prices over the next 18 months could pressure headline inflation higher in some OECD economies. This is because headline inflation is typically highly correlated with energy prices, even when core inflation remains subdued.
Francisco Blanch is head of global commodities research, Banc of America Securities-Merrill Lynch. This analysis first appeared in the Global Energy Weekly: Oil and Money report from BAS-ML.
