A Libyan oil worker walks in front of a refinery inside the Brega oil complex, in Brega east of Libya, in this Feb. 26, 2011 file photo. The turmoil in Libya has affected the world’s oil supply. (AP)
By KHALIL HANWARE | ARAB NEWS
Published: Jul 26, 2011 23:37 Updated: Jul 27, 2011 00:04
JEDDAH: Major analysts in the region are predicting a sharp increase in oil prices if the US defaults on its debt. Although oil producers will benefit from such moves, a crude price increase is not necessarily a good event for the global economy and it could lead to price pressures building globally, they pointed out.
The debt crisis rattles global markets as oil demand is once again clearly above pre-crisis levels and is continuing to grow, thereby eating into the cushion of spare capacity that now is largely in Saudi hands.
Their comments came as New York’s main contract, light sweet crude for delivery in September, advanced by just 14 cents to $99.34 a barrel on Tuesday.
Brent North Sea crude for September eased seven cents to $117.87 in London deals.
Jarmo T. Kotilaine, chief economist at the National Commercial Bank, said: “The main likely impact on Saudi Arabia would come from oil, the dollar, and financial market sentiment. In addition, Saudi companies and financial institutions would naturally be vulnerable to any disruptions in the normal operations of markets.”
He said a US default would significantly increase market uncertainty and risk aversion, which would probably continue to hold back the much-awaited recovery in the capital markets and in bank lending, even in spite of the favorable economic fundamentals in Saudi Arabia.
Any oil price correction – likely limited in duration – would similarly adversely affect the sentiment and would curb government revenues. However, the current break-even price is still, in spite of a major increase this year, comfortably below the prevailing market prices. Given the tightness of the oil markets, risks in this area should be relatively contained.
“A weaker dollar would risk stoking inflationary pressures in Saudi Arabia. Although inflation has broadly stabilized in recent months, it is historically high and more expensive imports would push it up somewhat,” Kotilaine said.
When the dollar falls, investors turn to commodities and stocks. The effect was apparent in early May. The US Dollar Index, which tracks the greenback versus other major currencies, dropped to its lowest level of the year. At the same time, oil prices rose above $113 per barrel, the highest level since 2008.
“A US default would almost certainly lead to a weaker dollar but it’s not clear if this leads to a more generalized economic slowdown, which is not impossible, or an increase in commodities priced in dollars such as oil. Certainly the linkage between a weak dollar and higher oil prices is there but we are in unchartered territory, as the US has never defaulted so we don’t know how markets would react to such a historic event,” John Sfakianakis, chief economist at Banque Saudi Fransi, said.
He said in the event of a oil price increase, the oil producers will benefit but at the same time an oil increase is not necessarily a good event for the global economy and it could lead to price pressures building globally. A weaker dollar might not lead to purchasing power declines as long as purchases are kept within dollar-denominated goods. However fundamental questions about the US economy will have to be asked in the event of a default.
Kotilaine also said the investor focus on the possibility of a US default is driven by the extraordinary nature of such a potential event.
The US dollar has been the linchpin of the global economy throughout the postwar era and a default – or a US credit rating downgrade, which may materialize even if a deal on the debt ceiling is reached – would clearly take the markets and the global economy into uncharted waters. Even a short-term technical default would increase the mounting pressure on the Dollar and intensify questions about its global stature.
He said the effect on such an outcome on oil prices would be ambiguous.
While it is true that a weaker dollar has in recent years tended to go hand in hand with the appreciation of real assets and commodities, including oil, a US default would have far broader implications. Above all, it would inject a massive additional dose of uncertainty into the markets, thereby fueling risk aversion.
It would also result in significant market disruptions as long-standing assumptions and asset valuations would have to be revised.
This would likely bring demand concerns to the fore again and result in at least short-term downward pressure on oil.
The domestic US and potential global policy response to a default-type would dictate the subsequent developments.
But what is remarkable about the performance of oil even in the face of this extraordinary cluster of global uncertainties is the exceptional resilience of the price.
Even though it has been experiencing volatility of late, the oil price is at a historically high level and recent interventions – such as the reserve release by the IEA (International Energy Agency) – have done little to alleviate these trends.
The fundamental problem is that oil demand is once again clearly above pre-crisis levels and continuing to grow, thereby eating into the cushion of spare capacity that now is largely in Saudi hands.
It is unlikely that much can be done to significantly boost production in the near term, which makes for an environment tight markets and concomitant speculative pressures.
In the longer run, the outlook is less clear because of factors such as growing unconventional hydrocarbons production, the role of Iraq, and the evolving policies on energy use and production around the world, Kotilaine added.