In Brief
- A third month of the Hormuz blockade has created a 14mbd supply gap, pushing Brent crude up 63% to a high of USD 118/bbl.
- The disruption follows a two-stage path: energy price inflation squeezing the economy first and forcing central bank action, followed by restricted petrochemical energy supply that risks cutting industrial output and dampening growth.
- Investment impact from higher energy costs varies depending on the damage to growth. We see energy and materials, inflation-linked bonds, and gold outperforming cash in a scenario of sustained supply disruption.
The blockade of the Strait of Hormuz has entered its third month. This implies the global economy, especially Asia, is running with a supply gap of 14 million barrels of oil per day (mbd), alongside natural gas and a broad range of petrochemicals and derivatives that go into fertilizers and a wide range of industrial processes. In April, the pace of oil inventory drawdown was approximately 7.1mbd. If this inventory drawdown continues, the disruptions are no longer only about higher prices, but also more restricted supply of various essential materials that forces production and economic activities to slow down. While we still hope for a removal of the blockade in the coming weeks, the stalemate in negotiations between Washington and Tehran means we should not be complacent. In this On the Minds of Investors, we review previous episodes of oil price surges and the reaction of various assets.
The context matters
A thunderstorm could be good or bad depending on what happened earlier. If it comes after months of drought, some heavy rain would be welcome, even life-saving. But if it comes after two weeks of torrential downpour, a thunderstorm could bring more flooding or landslides. The same is true of the backdrop of higher oil prices.
We looked at several periods of oil price surges since 2000 (Exhibit 1). In most of these episodes, the rise in oil prices was related to demand recovery, such as from the Global Financial Crisis in 2008, or the COVID pandemic in 2020-2022. They usually rebound from a depressed price level. While there were occasions of supply disruptions, the magnitude was small and could be offset by other oil producers.
The Russia-Ukraine conflict saw a cutback in oil production, but the quantity of oil and gas impacted was smaller than in the current bout. Russia was producing around 10% and 17% of global supply of oil and natural gas, respectively. While the impact on Europe was significant, the fact that the energy supply cutoff was due to sanctions, rather than a physical blockade, meant that the global impact on supply chains was less abrupt. The rebound from the pandemic around the same time also meant growth momentum was more robust. Central banks were forced to tighten policy from an ultra-loose stance towards neutral.
Two stage process – inflation shock, then growth shock
There are two aspects of the current bout of energy supply disruptions that make it different from previous episodes and challenging for the global economy.
First, the rise in energy prices is rapid. Two months into the conflict, Brent crude reached a high of USD 118/bbl in late March, or 63%. If we reach USD 150/bbl in the coming weeks, this would be more than double the oil price since the war began. Historically, a rise in energy prices of this magnitude would take place over quarters, if not years, if driven by strong demand. The supply-disruption nature of this episode is squeezing energy prices higher.
Someone needs to bear the cost of more expensive energy. This could be the businesses, through their profitability, or it could get passed on to consumers. There is a strong correlation between global crude oil prices and U.S. retail gasoline prices, which means the higher costs are predominantly passed on to consumers. The latter would create higher inflation, and this could prompt central banks to raise rates if they worry about the second-round effects. While the U.S. Federal Reserve is content with adopting the “wait-and-see” approach, the European Central Bank and the Bank of England are ready to tighten monetary policy to pre-empt inflation risk. Governments may also opt to dampen the impact on businesses and households by using fiscal policy to provide a buffer via fuel subsidies or price caps.
Second, an extended period of supply disruption further restricts the supply of energy and petrochemicals to the global economy. The energy market’s response to changes in the demand-supply balance tends to be slow, given the lengthy investment cycle to drill and refine. A rise in price due to a shortage would force demand destruction, since supply cannot be raised quickly.
This is relevant in this episode of energy market disruption and is not associated with a demand-driven price surge. Some products, such as sulfur, are by-products in oil and gas refining and processing but can be used as raw materials. As inventory declines, any shortage of these products for energy generation and industrial production would imply a cutback in economic activities, weaker growth, or even recession if the disruption is extended. Unfortunately, it is challenging to pinpoint the exact turning point as the speed of inventory drawdown varies from one market to another, as well as because of the opaque starting inventory level.
Meanwhile, the higher cost of living and doing business likely undermines consumer and business confidence. Even though the pass-through of weaker sentiment to consumption and corporate investment would take time, this adds to the downside risk to the global economy with an extended disruption in global energy supply. While inflation alone would prompt higher rates by central banks, this stagflation scenario would present central banks with a serious dilemma, and they could be forced to cut rates to protect growth.
What does this mean for investors?
Having looked at these episodes of higher energy costs, this current episode is unique since higher oil prices in recent decades were not associated with such an abrupt supply shock. Some may refer to the oil embargo and the Iran-Iraq war in the 1970s, which was also a physical supply disruption. Yet this would be of limited value as a reference, since the global economy has gone through significant shifts in structure and technological advancement. We are now less oil- and fossil-fuel-dependent than half a century ago. The composition of markets is also leaning more towards technology and services, instead of manufacturing and materials.
A historical comparison of asset performance during these episodes found that in most cases, risk asset performance was sound when price increases were associated with demand recovery. This is not surprising given equities should rebound during economic recovery. Hence, we focus more on the onset of the Russia-Ukraine conflict (Exhibit 2).
There are several observations:
- Across all episodes, the energy and utilities sector of the S&P 500 maintained positive returns.
- During the Russia-Ukraine conflict episode, cyclical sectors had a tougher time due to the prospects of higher rates by central banks. This includes financials, technology, consumer discretionary, and communication services.
- In fixed income, inflation-linked bonds outperformed developed-market government bonds across all episodes, and they were one of the few fixed income sectors that generated positive returns during the Russia-Ukraine war episode. Unsurprisingly, the long end of the yield curve outperformed the short end when growth was under pressure, even if the threat of inflation remained.
- Gold was also able to provide some offset against market correction, but the magnitude of return is not very consistent.
At the time of writing, there is still not a clear path for Washington and Tehran to agree on the terms to reopen the Strait of Hormuz. Investors should hope for the best but also prepare for a rise in volatility if the growth outlook is threatened by the disruptions mentioned above. The good news is that history has provided some guidance on how to prepare for such volatility, and it is not just rush back to cash.