Like old generals, investors and journalists are good at fighting the last war. The initial market and media response to rising tensions in the Gulf last week was, therefore, entirely predictable: oil and gold up, shares down, leading to a rash of stories about last year’s bull market hitting the buffers.
At any point in the past 50 years that reaction would have made sense. For as long as I can remember, instability in the Middle East has been bad news for investors in the rest of the world. More expensive energy, higher inflation, recession, falling share prices.
This time around, however, the knee-jerk reaction was almost immediately reversed. The oil price rose in the aftermath of the assassination of Iran’s totemic general, Qassem Soleimani, in Baghdad. Within three days it was back where it started. The S&P500 index continued to hit new all-time highs. Crisis, what crisis?
This pattern, as the market’s muscle memory temporarily kicks in before a more sober assessment takes over, is becoming the new normal. Last September, investors reacted in much the same way to the drone attacks on a key Saudi refinery. At the time, this looked like the real thing - it disrupted 5% of global oil supply - and the initial response was the biggest one-day spike in the oil price since the 1980s. But within less than two weeks, the cost of crude was 16% off its post-attack peak. It was as if the strike had never happened. Shares almost immediately set off on their fourth quarter Santa rally.
What has changed? Why do investors no longer seem to care what’s happening in the Middle East? And what does this new reality mean for our investments?
First, investors are relaxed because it is clear that neither the US nor Iran is serious about starting a war. The responses of both sides to rising tensions have been carefully calibrated to demonstrate strength and resolve at home, while stopping short of provoking further retaliation. Iran’s attack on US bases in Iraq, for example, seemed expressly designed not to cause any American deaths.
Second, neither side has any desire to meaningfully disrupt the supply of oil. Iran has the ability to block the straits of Hormuz, but it won’t because that is the gateway to supplying China’s energy needs. In the face of US sanctions, it needs more than ever to keep this front door to Asian markets open. In a pre-election year, Donald Trump has no interest in anything that would cause more than a temporary hike in the cost of filling America’s gas tanks.
Third, investors know that any apparent supply shortages are illusory because Opec and Russia have been cutting back on production for the past couple of years to keep the oil price higher than it would otherwise be. Filling the gap is as simple as unwinding some of the agreed output cuts. The reality is that the global oil market is oversupplied thanks to the rapid growth in recent years of US shale production. It will take more than controlled sabre-rattling to change that balance.
The US used to be a huge importer of oil. Now it is frequently a significant exporter. In October, it sold 3.4 million barrels of oil a day more than it bought. That month it accounted for 12% of global oil exports. That is less than half Saudi Arabia’s 27%, but it compares with zero a decade ago.
US oil production is different from that in much of the rest of the world for another important reason. Unlike deep-sea fields, or those in other harsh and difficult to reach environments, shale is quick to switch on and off. Such is the responsiveness of US shale to movements in the price of oil, that it has made the market’s self-correcting mechanism much more rapid. Higher price equals higher supply, almost immediately.
So, a sustainable rise in the oil price is now much less likely than it was in the past. Even if it were not, however, it is likely that it would have less of an impact on the global economy. The oil price simply matters less.
The first reason for this is, again, America’s new role as an oil exporter. Whereas a sharp rise in the oil price was an unqualified negative in the 1970s, today there are plenty of Americans who stand to benefit.
Second, industry around the world is far less energy-intensive than it used to be. It is estimated that a unit of GDP growth in America today requires only a third of the energy that it did in 1973. In part this is to do with more efficient use of energy; in part it reflects greater use of renewables. American households, too, are significantly less gas-guzzling than they were. A 45% rise in US households since 1980 has resulted in only a 10% rise in energy use. One key reason why the global economy is less hungry for energy is the shift from manufacturing to services.
Breaking the historic link between the oil price and economic growth is bad news for the long-suffering inhabitants of the Middle East. Knowing they can act with relative economic impunity will embolden both Washington and Tehran, further entrenching the miserable round of instability and violence in the region.
But the reduction in the global economy’s energy-intensity, and lower dependence on the Gulf states, is a positive for investors. A more predictable, range-bound oil price is good news for businesses, which can invest with greater certainty about demand for their products and the cost of producing them. It should lead to less volatility in financial markets which might justify higher valuation multiples than in the past. It points to lower inflation and interest rates.
Important information: The value of investments and the income from them can go down as well as up, so you may get back less than you invest. This information is not a personal recommendation for any particular investment. Overseas investments will be affected by movements in currency exchange rates. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.