I’m undertaking a 1000-day reinvention project, blogging here daily to track my progress. In Friday Flash, I share an epiphany or aha moment from the past week.
Yesterday was a risk -off day in the financial markets, as the world grappled with the ramifications of war in the Middle East. The current presidential administration faces the reality that they can’t simply decide when the conflict is over, because it’s not a one-sided decision to stop it: Iran and Israel get a say too.
The shock to the oil market has been called the “largest supply disruption in history.” The 32 members of the International Energy Agency (IEA) have agreed to release 400 million barrels of emergency crude oil to respond. That includes 172 million barrels from the United States’ strategic petroleum reserve. Brent crude, the benchmark used for global oil pricing (vs. WTI, used as the US benchmark) is still over $100 this morning, an almost 70% increase since the beginning of the year. The price went up as high as $117 during the initial panic.
What makes this situation different from past Middle East related oil shocks is the use of the Strait of Hormuz for transporting liquefied natural gas. Today, 20% of the world’s LNG passes through the strait. Cutting off that flow means higher electricity and heating prices in Europe and Asia. Furthermore, the strait is also used to transport fertilizer and fertilizer components and helium, used in semiconductor manufacturing.
We can expect two phases of this crisis: the initial spike in prices of the commodities and price increases in derivative goods and services related to that. Airfare will likely increase, shipping will become more expensive, and eventually food prices will rise (as the fertilizer crunch affects farming). Later, a demand destruction phase will occur and we’ll see an economic slowdown. Households (especially in Europe and Asia) will see higher gas, food, electric, and heating costs. Businesses will face higher expenses and consequently lower profit margins.
Central banks may respond by raising interest rates to fight the inflation caused by the commodity price spike. This doesn’t make total sense to me, as a supply constraint is very different from excess demand. Raising rates during a supply shock causes pain on top of the pain of higher prices. Such an action doesn’t produce more of the oil or other commodities that are needed. And the price rise in the commodities sows the seeds of its own resolution, in the form of demand destruction.
Half a world away in Brazil, what are the effects of this crisis?
I’m particularly looking at Brazil to see what their central bank does. I’m leaning towards Latin America in my emerging market portfolio sleeve (and away from Asia), since Latin America includes commodity exporters insulated from the Gulf chaos means they may go through this crisis relatively unscathed.
But they are not, in fact, insulated from the chaos. Take Brazil as an example.
Brazil exports soy, corn, and beef. It also produces nearly 4 million barrels per day of crude oil, but its domestic refineries aren’t equipped to process it all into the fuels the country needs. So Brazil actually imports about 25% of its diesel and 10% of its gasoline.
For months, most observers have expected Brazil to start cutting interest rates at its next meeting on March 17-18. The current interest rate is a whopping 15%, one of the highest real interest rates in the world. Before the oil spike, a 50 basis point cut was priced in, but now expectations are split 50/50 between that and a 25 basis point cut.
Brazil is in a tough spot. They export significant agricultural products to the Middle East, much of it moving through the Hormuz Strait to reach its destination. Meanwhile, fertilizer imports will be limited in supply, increasing farming costs for the next growing season. Both of these will slow growth, so why not do the interest rate cut?
Brazil’s 12-month inflation rate slowed in February to 3.81%, its lowest level in almost two years. Officials have been holding the main interest rate, the Selic, at 15% for several months to attempt to reduce inflation. Some economists think the Banco Central do Brasil (BCB) may not do any rate cut at all, some are now calling for just a 25 basis point cut, and some think the 50 basis point cut will still happen. The inflation decrease, the strength of the Brazilian real against the dollar (a bit weaker since the conflict, but holding up), and the growth-negative effects of the Middle East crisis may lead them to go forward with the bigger reduction.
Yesterday, Brazil’s government announced temporary measures to respond to price increases arising from the U.S.-Israeli conflict with Iran. They cut the federal taxes levied on diesel fuel to zero and imposed a 12% tax on crude oil exports and a 50% tax on diesel shipments. These actions may hold down the fuel price domestically and provide justification for the BCB to cut rates as planned.
And in the U.S.
Before the war broke out, traders expected a quarter percentage point rate reduction in June, and then one in September, and possibly even three this year. Now, expectations are that the Fed will hold interest rates where they are at their meeting next week.
Today the PCE (personal consumption expenditures) inflation measure will be reported. This, not the CPI, is what the Fed generally looks at to determine whether inflation is ok in their view or not. Forecasts call for it to tick up to 3.1% from 3.0% last month.
While the U.S. is somewhat insulated from price increases related to the war, because we are a net energy exporter, the Brazilian example shows how complicated supply chains are even for countries considered exporters not importers.
In many ways, we are not insulated from the crisis –
- We produce mostly light sweet crude from shale but many of our Gulf Coast refineries are designed for heavy crude. We have to import heavy oil, from Canada, Venezuela, and the Middle East. Asia will compete with us for all that oil.
- Oil and gas are global commodities. U.S. producers sell to the highest bidder even if that’s not in the U.S.
- We are a major exporter of liquefied natural gas (LNG). There will be a massive increase in export demand from Asia and Europe. It could pull domestic supply away, leading to higher heating and electricity bills for us.
- Shipping costs will increase, increasing costs of imported electronics, clothes, and parts.
- If the dollar continues to strengthen (as it has for the most part during this conflict), our non-energy exports will become more expensive for the rest of the world, which could hit our economic growth.
Any flash or epiphany?
This is my realization for today: country around the world faces difficult decisions and impacts in the face of a Middle East war. Global supply chains mean that no country is insulated from its effects.