Why Libya Could Tank the Market
03/04/2011 7:00 am EST
Stocks didn't crater during Egypt's revolution, but there are plenty of signs suggesting that Libya's turmoil could lead to more pain, even if Gaddafi remains.
It's different this time.
No, no, it really is.
Libya isn't Egypt, and the effects on the stock market this time will be different from those of the earlier crisis.
Different enough, in my opinion, that you need to factor them into your investment strategy. Yet not so different that you need to tear up your plans for 2011.
The short-term effects don't look that all that different, I admit—especially if you look mainly at stocks of developed economies. Egypt's revolution, as scary, exciting, and important (especially for Egyptians) as it was at the time, created barely a ripple in US stock markets:
- On January 25, the "Day of Rage," the S&P 500 Index closed at 1,291.
- On January 28, the biggest drop during the crisis, the index closed at 1,276.
- By January 31, when 250,000 protesters gathered in Tahrir Square, the index was up to 1,286.
- By the time Hosni Mubarak resigned on February 11, the S&P had climbed to 1,329.
Why Libya Matters More
For one, the Libyan crisis is already longer than the Egyptian crisis. Demonstrations began on February 15 in Benghazi, and the crisis was in Day 16 as of Thursday.
The Egyptian crisis—from the "Day of Rage" to Mubarak's resignation—ran for just 17 days.
At this point, US stock-market reaction to the Libyan crisis isn't a whole lot bigger. The S&P 500 closed at 1,328 on the day of the Benghazi protests; fell to 1,306 on February 17, when Libya saw its own "Day of Rage" demonstrations; rallied; then fell back to 1,306 on March 1.
If you want to see "different," you have to look at oil prices.
Oil traded at $89.11 a barrel on the New York Mercantile Exchange on January 21, just before the start of the Egyptian crisis. It traded at $89.03 on February 4, a week before Mubarak resigned. So far, so good.
In the case of the Libyan crisis, on the other hand, oil traded at $86.20 on February 18, a few days after the initial Benghazi protests—yet by March 2, the price in New York was over $100 a barrel, at $101.57.
It stands to reason. Egypt isn't a major oil exporter—the country actually has to import oil to meet its domestic needs—even as it increases its production of natural gas. Libya is the world's No. 12 oil exporter, with exports of 1.6 million barrels a day.
That production is especially hard to replace, because Libya is a major source of light, sweet crude, which is easy for the world's refineries to handle.
Saudi Arabia would have no problem right now ramping up production to meet any shortfall from Libya; the Saudis enjoy about 4 million barrels a day in excess capacity. But much of its oil would be heavy, sour grades that are harder to refine.
The differences between Egypt and Libya also argue for a difference in how oil will behave once the latter's crisis is over.
In the case of Egypt, any spike in oil prices was justified only if you believed that the crisis would endanger the 4 million barrels a day that flow through the Suez Canal and into a major European pipeline. Take out that supply route and the shortfall equals Saudi Arabia's total excess oil capacity.
When the crisis ended and the canal and pipeline were clearly still intact, there was no reason for oil not to drop back to its former price.
In the case of Libya, there are well-founded worries about damage to its oil fields, pipeline and terminal shutdowns, and the flight of experienced engineers behind them. It sure doesn't calm nerves when Muammar al-Gaddafi threatens to blow up the country's oil fields—especially when he's clearly capable of just about anything.
Reports out of Libya testify to falling production during the crisis. The state-owned National Oil Company of Libya, which normally pumps about 420,000 barrels a day, says production has dropped to 100,000 barrels a day.
No one knows how much damage has been done to oil fields and transportation systems—and no one will know until the war between Gaddafi and the protesters is over. That nervousness will add to oil prices. Nonetheless, I expect that the end of hostilities will show the damage is less than is feared right now.
Next: Where Is Oil Heading Next?|pagebreak|
What If Regime Change Spreads Further?
I don't expect oil prices to drop back immediately to their pre-crisis levels, as they did after Egypt.
No one expects that protesters in Libya stand a chance of toppling the Gaddafi regime. There is no organized opposition, and Gaddafi has kept the army splintered so it can't offer the kind of alternative institutional power that pushed Mubarak out the door in Egypt.
And this is one of the world's most oppressive and brutal regimes, with no apparent compunction about using any measure of force against its opponents. It is hard to imagine that protesters could put it on the ropes.
Still, it's worth asking: If Gaddafi falls when everyone thinks it is so unlikely, what regime isn’t in play? (The high population of young people in these countries, which has economic benefits, has also contributed to unrest. For more on this, see my recent column on the demographic dividend.)
Could Iran be next? The regime looked to have closed potential rifts between President Mahmoud Ahmadinejad and Ayatollah Ali Khamenei—and to have pushed the opposition into quiet—but the arrest of opposition leaders and their families has prompted rage in the streets of Tehran.
It is certainly possible to imagine a collapse in government here. Iran is the No. 4 global oil exporter, at about 2.4 million barrels a day.
And Saudi Arabia? The Saudis have clearly been unnerved by the protests in neighboring Bahrain, where a Sunni ruling family governs a restive Shi’a majority. (Much of Saudi Arabia's oil comes from the country's Eastern Province, where Shi’a outnumber Sunni in many areas.)
On March 1, global oil markets were roiled by news that Saudi authorities had detained a Shi’a cleric in the Eastern Province after he called for a constitutional monarchy in the country.
Saudi Arabia is the big prize among oil producers, because it exports 7.3 million barrels a day and manages the world's excess production capacity. There simply is no way to replace Saudi production.
I think all these fears are enough to keep oil higher post-Libya. The question is how much higher—and figuring out the answer to that question depends on how different the Libyan crisis turns out to be.
Where Is Oil Heading Next?
Oil prices were on a steady climb in 2010, even before the Egyptian and Libyan uprisings, trading in New York at $75 a barrel on September 3, at $87 on November 5, and at $91 at the end of December.
That's quite a move, considering that oil was trading at just $37 a barrel in January 2009.
The pre-crisis price increase had everything to do with the recovery from the global recession that had depressed demand. That recovery continues.
There's plenty of talk about growth slowing in the United States or China or India—but it's still growth. The International Energy Agency reports that global oil demand climbed by 2.8 million barrels a day in 2010. The agency projects an additional increase of 1.5 million barrels a day in 2011.
Even without worries about Libya, Iran and Saudi Arabia, oil prices aren't going down this year. That doesn't seem to be such a big deal, until you consider how far prices have come and where the world stands now in its fight against inflation.
Next: Where to Invest|pagebreak|
More Inflation Pressure
A rule of thumb is that every $20 increase in the price of a barrel of oil whacks 2 percentage points off GDP growth in the ensuing two years. Well, the world already had its $20 increase from January 2009 ($37 a barrel) to $57 a barrel in May 2009, and then again to $75 a barrel in September 2010.
Those earlier increases probably didn't matter a whole lot, because the world was crawling out of a deep recession and global demand was still very low.
Now we're looking at a third potential $20-a-barrel increase, from $75 to $95—and this one is going to hurt. But it's not going to hurt evenly over the globe. It's going to hit oil-importing economies harder than oil exporters. Turkey is going to feel more pain than Canada.
It's going to hit economies that use energy inefficiently harder than those that are relatively efficient. For example, India—according to the Indian government's own "Hydrocarbon Vision 2025" report—is going to take a hit to growth because it takes 1.1% more oil to add 1% to GDP there.
That's a high ratio, not only in comparison to developed economies (most developing economies use energy less efficiently than most developed economies), but also in comparison to developing-economy competitors such as China.
This latest potential $20 increase in the price of oil couldn't come at a much worse time for countries already deep in the inflation fight.
Higher oil prices feed into higher inflation. This requires governments to act more forcefully to raise interest rates to dampen growth, at the same time that higher oil prices are themselves acting to lower growth rates. That leaves many governments trapped between a rock and a hard place.
Many will, I assume from past observation of politicians, decide to opt for waiting as long as possible to do something painful until they deem it to be absolutely necessary. (For more on this dynamic, see my recent column on the inflation trap.)
I think that dynamic increases the danger that countries such as India, Turkey, and China—which are already on the brink of losing control of inflation—will wait too long to act. If so, they will have to take much more drastic action to get inflation back under control.
The other danger is to economies with already low growth rates, where inflation is pushing up against central bank targets. The European Union is the best (or worst) example of this.
The danger for these economies is that the central bank will feel compelled to raise interest rates, and that higher-than-expected energy prices will then push them back into a near-recession.
Where in the World to Invest
Higher oil prices certainly don't make the world an easier place to invest.
I'd still favor the United States in the first half of 2011, because inflation is currently so low and growth has decent momentum. What happens in the second half is a different story.
Higher oil prices also suggest a deeper look at Japan, one of the world's most efficient energy consumers. The best Japanese exporters actually get some advantage from higher energy prices against their less energy-efficient competitors.
And among emerging markets, I'd favor countries that:
- Don't face huge odds against winning their inflation battles
- Have central banks that are reasonably tough on inflation
- Are energy producers (even if not oil producers)
- Have decent economic momentum
Three emerging countries that come to mind are Brazil, Colombia and Poland. In the developed world, Australia and Canada also fit this profile.
I'd stick with my suggested overweighting of the United States in the first half of the year, then look at the countries I've mentioned above in the second half. That assumes, of course, that none of our worst fears about the world's oil producers comes true.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund (JUBAX), may or may not now own positions in any stock mentioned in this post. For a full list of the stocks in the fund as of the end of January, see the fund’s portfolio here.