Oil Above One Hundred Dollars: How an Energy Shock Moves Through the Economy
This week the price of a barrel of Brent crude, the international benchmark for oil, rose above 112 dollars, its highest level in five months. The trigger was a series of deadly attacks in Saudi Arabia, which fuelled fears that tensions in the Middle East could disrupt oil supply. On the financial markets this caused unease: equities fell and investors sought the safety of government bonds.
Why oil works its way through everything
Oil is not an ordinary commodity. It is embedded in virtually everything that is produced, transported and sold. Fuel for aircraft, ships and trucks, plastics, fertiliser and, in many countries, electricity generation as well, all depend directly on the oil price. When oil becomes more expensive, prices at the pump rise first. After that, with some delay, come the costs of transport, food and other goods.
For island economies that import almost all of their fuel, that effect is stronger still. A large part of what sits on the shop shelf arrives by ship or by air, and electricity and drinking water are often produced with imported fuel as well. A higher oil price therefore feeds through to the cost of living via many channels at once.
The lessons of earlier shocks
History knows several major oil shocks. In 1973 and 1979, political conflicts in the Middle East led to a sharp rise in the oil price, and in 1973 even to a fourfold increase within a matter of months. The consequences were high inflation, rising interest rates and economic contraction across large parts of the world. In 2008 and again in 2022, rapidly rising energy prices put pressure on households and businesses.
At the same time, those episodes show that economies adapt. After the shocks of the 1970s, cars became more efficient, countries began saving energy and dependence on oil gradually diminished. Today, far less oil is needed for the same amount of economic activity than fifty years ago. An oil shock therefore still hurts, but the blow is generally smaller than in the past.
Inflation and interest rates
The greatest concern among economists is not the oil price itself, but its effect on inflation and interest rates. Central banks aim to keep price increases around two percent, and more expensive energy makes that harder. In the United States the yield on ten-year government bonds already stands at around five percent. A persistently high oil price reduces the likelihood of rates falling in the short term, with consequences for mortgages, loans and company valuations.
For companies, it matters a great deal whether they can pass higher costs on to their customers. Businesses with a strong market position, supplying something customers cannot easily do without, adjust their prices without losing many customers. Companies already operating on thin margins, by contrast, see their profits shrink quickly. In a period of rising costs, pricing power is one of the most valuable characteristics a business can have.
Diversification as a buffer
No one can predict with certainty how a conflict will develop or how long a higher oil price will persist. That is precisely why investors who do not depend on a single forecast are generally better protected. Capital spread across different sectors, regions and types of investment absorbs a shock in one part of the economy better than concentrated capital does. Patience and diversification remain, now as ever, the most reliable buffers against uncertainty.
Disclaimer. This article is published by Solar Asset Management N.V. for general informational and educational purposes only. It reflects the personal views of the author at the time of writing and does not constitute investment advice, a recommendation, an offer, or a solicitation to buy or sell any security or financial instrument. References to specific companies are illustrative and should not be interpreted as buy or sell recommendations. Investing involves risk, including the possible loss of principal. Past performance is not a reliable indicator of future results. Readers should consult a qualified financial advisor before making any investment decision based on their personal circumstances. Solar Asset Management N.V. is supervised by the Centrale Bank van Curaçao en Sint Maarten (CBCS).
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