The oil market is one of the deep-seated constituents of economic growth in the world. In the past, oil shocks have been responsible for major turnarounds in the level of income and employment worldwide. In real terms, oil is today getting as expensive as it was in the 1970s and 1980s.

And yet, unlike the 1970s and 1980s, we have not experienced a major supply shock. So is it just a case of demand being so strong that oil prices will persist to soar? The prevalent belief today is that, because of massive incremental demand from Asia, oil prices will settle high and possibly climb further. The United States is not the sole one being hit by major hikes in oil prices; even across Asia, a rise in oil prices is taking a bite out of growth. Everywhere we care to look, it feels as if economic growth is softening and some of that is linked to the current time of the cycle. One certainty is that the current high real cost of energy is dragging growth lower. There exist in the financial markets a number of prices such as prices of copper, aluminum and Baltic Freight rates that are highly correlated to global growth. Lately, a majority of these prices have started to trade below their moving averages, hereby highlighting the threat of a slowdown.

This has a huge impact on the availability of liquidity. Assuming that the world keeps around 100 days of oil consumption in inventories, this means that the cost of keeping oil has lately been mounting sharply, illustrated by a $ 300 b drain on liquidity. In an ample liquidity environment, such as the one that we have experienced over the last couple of years, it’s simple for oil to rise similar to a “rising tide that lifts all boats”. As central banks start tightening, and as the US Current account deficit starts to improve, global liquidity conditions will change from being a tailwind to oil prices to a headwind. As mentioned before, almost all the macroeconomic indicators are pointing towards an abatement in the pace of economic growth. Historically, a deceleration in the rate of growth has usually triggered a fall in oil prices. Of course, it could be different this time, but from expensive experience, investors have learnt not to endow on that premise anymore.

We would not be surprised to see activity in the oil futures market die down and oil prices return to the mid US $ 30s/barrel. But having said that, there is always the possibility that we are wrong and that things are different this time given dwindling and exponential demand. Therefore, there is the possibility that the price of oil rises over US $ 50/barrel in the near future.

The rise in oil prices seems to be already impacting economic growth around the world: OECD leading indicators have rolled over, confidence surveys have been coming in low, employment growth seems to be slowing down as well. The rise in oil prices has also been a major drain on global liquidity. The simple fact might explain the lackluster performance of most financial asset classes over recent months.

The oil futures market will undoubtedly determine the pace of economic growth in the pending months, and whichever way oil prices end up going, it will be interesting to observe the costs.

<B>Nitish Benimadhu

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