Figure 3 - Oil/Metal price move in line with global industrial production (IP)
Oil and metal price cycles tend to be synchronised with global economic activity (see Figure 3). As such they can provide a good barometer of economic activity before official statistics become available. Likewise projections of global economic activity can provide an indication of the likely direction of these prices.
Reflecting weaker global economic activity in the second half of 2012, upward pressure on the oil price is expected to ease. The consensus in the oil market indicates a broadly stable price of West Texas Intermediate oil at around UD$92 per barrel by end-November and UD$96 in a year’s time.
However, this outlook is complicated by the Federal Reserve’s recently announced programme of monthly asset purchases, QE3, and the Eurozone crisis. One of the consequences of QE3 should be a weaker US$. Since oil, along with most other commodities, is priced in US dollars, a US$ depreciation will tend to cause oil prices to rise. Conversely, deterioration in the Eurozone’s debt crisis could lead to a sharp decline in oil prices. In practice, oil prices may remain volatile but further large rises do at least seem relatively unlikely in the short term.
Figure 4 – China dominates global metal markets
Markets are not expecting further metal price rises for the rest of 2012 (although again we can expect these to remain volatile). Metals rose in the first quarter of 2012 reflecting in part strong demand from China, but have since eased as inventories have built up and global demand growth slowed. Iron ore prices, for example, have tumbled by around 17% in the last two quarters to $100 a tonne.
China forms a large proportion of global metal demand (see Figure 4) and so has a major impact on global prices. On the supply side, many of the larger mills in China are being subsidised by local governments. They have been requested by the local authorities to maintain production levels to help the economy meet the government’s 7.5% GDP growth target for 2012 and sustain employment levels. The side-effect of this policy is set to continue to encourage steel production and put downward pressure on its price.
Figure 5 – Food prices jumped in July and have remained elevated
Food prices tend to be less sensitive to changes in global income than oil and metals – a feature of the 2008-9 global financial crises. But they are highly sensitive to supply conditions which can be erratic. The US, as one of the largest agriculture exporters in the world, heavily influences global food prices. News of drought conditions in the US caused food prices to jump in July (see Figure 5) and given that inventory levels are reported to be low, they may remain high for the rest of the year.
Countries in the Middle East and North and Sub-Saharan Africa are most exposed to sharp increases in food prices, where food accounts for a significant share of family expenditure (over half in some countries). A number of these countries are caught in a ‘subsidy trap’ which can place a heavy burden on government finances when prices rise.
The subsidy trap in Egypt: High commodity prices have exposed the need to reform domestic market distortions
Figure 6 – Net importers and exporters of commodities worldwide
Egypt is the world’s biggest importer of wheat, and also a net importer of sugar, rice and oil, all of which the Egyptian government subsidises for domestic consumers.
First introduced in the 1950s to promote social justice, subsidies now place a huge burden on government finances. Egypt currently spends around 10% of GDP on subsidies, more than it does on healthcare.
Subsidies are now seen as a tool for alleviating poverty even though 80% of the subsidies reach the non-needy, with only 20% concentrated on the poor according to the International Energy Agency. A dependence on subsidies has also stifled support for domestic agriculture – crop production fell between 2006 and 2010.
Global businesses need to be aware of the political and economic risks large subsidy programmes can bring. Rising food prices were a key contributor to the demonstrations that sparked the Arab Spring in 2010.
Nevertheless subsidy reform is drastically needed to sustain Egypt’s fiscal position. One option is to replace subsides with more targeted welfare measures, such as free education and healthcare. Other approaches centre around changing consumer habits – Egyptians now consume more bread per person than in any other country in the world.
An example of successful reform is Turkey, which abolished most subsidies as part of a broader programme of economic reforms in the 1990s. This brought in a new period of growth which allowed more money (in absolute terms) to be directed to the poor, not less.
Double-edged sword: Performance of Russia’s resource rich economy is driven by commodity prices
Russia’s GDP is heavily driven by commodity prices. It is the largest producer of gas, the second largest net exporter of oil and the third largest net exporter of iron and steel products.
Between 2000 and 2008, this economic structure paid dividends. The economy grew by an average of 7% per annum over the period on the back of oil price rises. This spurred a rapid accumulation of foreign exchange reserves and fiscal surpluses.
However, it is the impact of oil prices on the wider economy that matters most for those investing in Russia. The plummeting oil price in the wake of the financial crisis was a major contributor to the Russian economy’s contraction of 8% in 2009, one of the sharpest downturns globally, although it has bounced back since then as world energy prices have rebounded.
Russia’s dependence on oil – which contributes to almost a half of government revenue – has led to fiscal laxness in other areas of the budget. S&P estimate that Russia requires an oil price of US$120 to balance government finances in 2012, compared to US$20 in 2000. Put another way, a US$10 decrease in the oil price leads to a 1% of GDP decrease in government receipts.
The upshot for Russian-focussed businesses is that even a mild weakening of the oil price over the remainder of the year or in 2013 could significantly dampen economic activity and business confidence.
Industry focus: Airlines buffeted by high and volatile oil prices
Figure 7 – Airline stock price performance and oil price
A spike in oil prices affects airlines through lower revenues and higher costs, as reflected in airline stock performance (see Figure 7). Around one third of airlines’ cost base is made up of jet fuel, and is typically hedged. But the relationship between rising oil prices and slowing revenues – via slower demand growth – can be overlooked.
The International Air Transport Association (IATA) estimates airline revenues will grow by 5.7% in 2012. This is the lowest rate since the 2008-9 global recession. The two main sources of airline turnover – passenger and freight customers – have been adversely impacted by other factors of business confidence and global trade flows respectively. The latest data show demand for the lucrative high-margin premium seats have shrunk by 0.5%. Demand for freight meanwhile has remained at a standstill.
Some airlines have come up with innovative ideas to control costs and boost revenues. Cash-rich airliners are renewing their fleet with more fuel-efficient planes, while one US airline is attempting to control its fuel costs by buying a refinery. One strategy for revenue growth is to boost presence in unsaturated markets – for example, available seat kilometres (a measure of capacity) in Latin America have increased by 7.9% over the past 12 months, compared to almost zero growth in the US.