How oil shocks can be less shocking

Oil price shocks have an asymmetric and non-linear effect.

IT has been over seven months since the Israel-Hamas War erupted on Oct 7, 2023. Prices of Brent crude, the international benchmark, have broadly stayed range-bound though it has hit a high of US$92.16 for a barrel of crude oil (bbl) on Oct 16, 2023 and US$90.48 per bbl on April 5, 2024.

When Iran strike Israel on April 13 and was retaliated by Israel on April 19, the subdued reaction of crude oil prices to the historic attack stemmed from investors pricing in the risk prior to the event. This reflects a larger trend of market quietness since the start of the Israel-Hamas war.

Year-to-date, Brent crude prices have steadily marched by 12.9% to US$87.72 on April 19, 2024 (averaged US$82.92 in the first quarter of 2024) from US$77.69 on Dec 29, 2023.

Will there be a perfect storm in the oil market in 2024?

Multiple factors have raised crude oil prices higher post-Covid-19 pandemic recovery, hitting an average high of US$99.82 in 2022, before settling at US$82.62 in 2023 (US$70.44 in 2021, US$42.30 in 2020 and US$64.03 in 2019).

These are firming and higher oil demand, the Organisation of the Petroleum Exporting Countries and its allies’ voluntary curbs in oil production, the US shale oil activities stall after ramping up production over the past three years, and oil market sentiment.

Against this backdrop, a large shift in supply resulting from the war and political conflicts in the suppliers’ countries, especially in the Middle-East (which made up 34.5% of the world’s crude oil production; of which Iran 3.5% and Iraq 6.1%) can trigger oil price shocks.

Prices could go higher to US$100 per bbl if the military conflicts in the Middle East get worse.

The oil market stability can change rapidly. The military conflicts are high in the Middle East and there are fears of a spiralling regional war. It is a relief that the G7 major powers said they are committed to de-escalating the conflict between Israel and Iran.

An escalation into a full-scale war could send volatility and give rise to greater risk exposures in capital flows, trade flows and global commodity, energy and minerals markets as well as foreign exchange markets.

Oil price shocks have an asymmetric and non-linear effect. Price shocks that increase the price of oil tend to disrupt consumption, production and gross domestic product (GDP) growth as well as raise domestic inflation.

The transmission impact of an oil price shock on the global economy depends on several factors as follows:

> First is the size of an oil price shock, the durability of the shock and its perceived duration

> Second, the prevailing global economic conditions and political environment

> Third, the level of energy intensity – energy-intensive countries will feel a shock more than ones that do not heavily rely on oil

> Finally, the policy responses (fiscal and monetary) of policymakers and central banks.

We concur with the International Monetary Fund’s warning that an escalating Middle East conflict risks leading to higher oil prices, a reversal of the recent fall in inflation and a puncturing of the optimistic mood in financial markets.

Having learned from previous major oil shocks in 1970s, 1980s, 1990s and 2000s, the global economy has improved its ability to absorb oil price shocks amid reducing energy intensity and efforts to reduce fossil-fuel consumption as well as seeking alternative renewable energy. Countries have built strategic oil reserves for meeting emergency use.

Governments across the world have bolstered their defenses against oil price shocks. The immediate challenge is to manage a potential increase in headline inflation. They should also refrain from introducing price controls and price subsidies in response to higher oil prices.

While the policy responses cannot eliminate the impact, it can at least minimise it through the provision of social safety nets.

How is higher oil prices impacting the Malaysian economy

The overall spillover effects on the Malaysian economy are expected to be manageable via the following channels:

> Trade channel

In 2023, exports of crude oil make up 2% of total exports (RM28.7bil); liquefied natural gas or LNG 4.2% (RM59.6bil) and petroleum products 10.1% (RM143.5bil).

Malaysia has been a net importer of crude oil in 2022-2023 amid declining crude oil production over the years (average 535,104 barrels per day in 2020-2023 versus 663,091 barrels per day in 2016-2019).

The crude oil trade balance registered a deficit of RM32.2bil or 1.8% of GDP in 2023 (minus RM21.1bil or 1.2% of GDP in 2022), compared to an average surplus of RM9.8bil per year in 2000-2021.

In contrast, LNG has incurred an average trade surplus of RM55.5bil per year or 3.1% of GDP in 2022-2023 while petroleum products also generated an average surplus of RM10.6bil or 0.6% of GDP in 2022-2023.

Overall, the trade balance for oil and gas (O&G), which consists of crude oil, LNG and petroleum products, remains in a healthy surplus of an average of RM39.4bil per year or 2.2% GDP in 2022-2023. As a result, higher oil prices should be positive for Malaysia’s O&G exports.

Nevertheless, the supply oil shocks, slower consumer spending and investment demand due to higher oil prices and inflation would temper the global economy, especially the oil importing countries. As a result, Malaysia’s exports will be impacted via second order effect.

Additionally, the immediate concern is the disruption of trade routes in the region. Iran and Israel share a strategic location near important shipping routes, especially in the Eastern Mediterranean and Persian Gulf.

As a result, supply chain disruptions, higher costs and delays in global trade flows could be impacted by the shutdown or increased risk of these crucial waterways or even airways resulting from conflict in these areas.

> Financial channel

During the periods of high oil prices, investors usually become more uncertain about the economic and inflation outlook and the impact on corporate earnings which, in turn, may lead to higher equity risk premia, putting additional downward pressure on stock prices.

The volatility in global stock markets will generate volatility spillover on Malaysia’s equity market, especially the risk averse foreign investors who would seek shelter in safe-haven assets such as foreign bonds, foreign currencies and gold to hedge against inflation.

Gold prices have a unique relationship to geopolitical concerns – they rise in periods of conflict and uncertainty often signalling an erosion of investor confidence.

> Domestic prices channel

There are two spillover transmission channels on Malaysia’s inflation via imported inflation and fuel subsidy rationalisation.

The share of import content in domestic consumption is approximately 26%. Compounding the impact of imported price inflation due to higher oil prices is the persistent weakening ringgit.

Direct exchange rate pass-through to imports is evident, whereby 40% of exchange rate depreciation is translated to overall import prices. Bank Negara estimated that a change in 5% in the ringgit/US dollar will result in core inflation to increase by 0.2 percentage points.

The impact could be larger amid prolonged depreciation, particularly for key necessities with high import content such as food and beverages, restaurants and hotels (7%) and transportation (5%).

There is also a direct impact on headline inflation from the transport price component of the consumer price index basket, which carries a weightage of 11.3%. Of the transport component, diesel and petrol carries weightage of 0.2% and 5.5%, respectively.

Every 10% increase in petrol retail price is estimated to contribute 0.55 percentage points to the headline inflation.

Currently, RON95 and diesel retail prices are capped at RM2.05 per litre and RM2.15 per litre, respectively, despite Brent crude prices havinge increased by 12.9% to US$87.72 per bbl on April 19, 2024 compared to US$77.69 per bbl on Dec 29, 2023.

As we expect the targeted fuel subsidy rationalisation will not lead to a complete floating of the retail petrol prices but rather a gradual adjustment in prices, the impact on headline inflation will be manageable though the indirect impact arising from increases in prices of other goods and services could mean higher inflation rate.

> Budget deficit

Budget 2024 was based on estimated crude oil price of US$84 per bbl. For every US$10 increase in oil price, fuel subsidies are projected to increase by RM4.7bil per year while the oil-related revenue will increase by RM3bil-RM3.5bil, resulting in the overall fiscal balance to deteriorate by RM1.2bil-RM1.7bil or 0.06%-0.09% of GDP.

However, the federal government is expected to make some reordering of spending priorities to keep the fiscal deficit target of 4.3% of GDP in 2024 (minus 5% of GDP in 2023).

> Interest rate

Given the implementation of a gradual targeted fuel subsidy rationalisation and also largely cost-driven inflation, which itself will act to moderate consumer spending, Bank Negara is unlikely to raise interest rates to keep a lid on inflation.

Lee Heng Guie is Socio-Economic Research Centre executive director. The views expressed here are the writer’s own.

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