The Ukraine commodity shock

There will be a range of commodity impacts if Russia and Ukraine end up in open war. Oil and gas are the obvious ones as Russia-European pipelines are jeopardised. But there is also 34mt of iron ore to consider and a lot of wheat.   

If there were to be an oil price spike then other commodities would also rise in sympathy with the stagflation bid. Because of this, after an initial correction, the AUD may well rise in the event of war. 

JPM with the note:

Oil shocks have a long history of driving cyclical downturns, with US recessions often associated with oil price spikes (Figure 1). The latest geopolitical tensions between Russia and Ukraine raise the risk of a material spike this quarter.

That this comes on the back of already elevated inflation— running at a multi-decade high last quarter—and a global economy that is being buffeted by yet another wave of the COVID-19 pandemic adds to the near-term fragility of what is otherwise a fundamentally strong recovery.

Below, we consider a scenario in which an adverse geopolitical event between Russia and Ukraine materially disrupts the oil supply. This scenario envisions a sharp 2.3mbd contraction in oil output that boosts the oil price quickly to $150/bbl—a 100% rise from the average price in 4Q21. Given that this would be solely a negative supply shock, the impact on output is to reduce global GDP by 1.6% based on our general equilibrium model—discussed in detail below. With global GDP projected to expand at a robust 4.1%ar in 1H22, this shock would damp annualized growth to 0.9% assuming the adjustment takes place over two quarters. Inflation would also spike to 7.2%ar, an upward revision of 4%-pts annualized.

In addition to the drag from a sharp contraction in oil supply our models estimate, there are two other channels through which this shock could damage global growth. The first relates to the repercussions of a Russian intervention in Ukraine. The US, coordinating with allies, would likely impose sanctions on Russia. While the possibilities vary widely in scope, they will likely impact negatively on sentiment and global financial conditions. Second, our estimates incorporate the realized behavior of major central banks over the past two decades whereby oil price shocks associated with geopolitical turmoil have been perceived to pose a greater threat to growth than inflation. Against the backdrop of a year of already elevated inflation and extremely accommodative policies, central banks may display less patience than normal—particularly in the EM, where rising global risk aversion may also place downward pressure on currency values.

It is important to recognize that the scenario of a jump in the oil price to $150/bbl is premised on a sharp and substantial shock to the oil supply. History has proven that such large and adverse shocks do material damage to the macroeconomy. In this regard, the results reported here should not be a surprise but seen as useful for quantifying the damage based on a carefully specified general equilibrium model using generally accepted elasticities. They are also useful for better understanding the issues that may cause the outturn to deviate from this benchmark model. The exercise does not assess the impact of a slower gradual shift higher in the price of oil from increasing demand in the face of a persistent and gradual undersupply of oil. These more constructive upside scenarios are considered in other J.P. Morgan research.

Context matters

The heightened risk of a sharp rise in the price of oil raises three contextual factors that are key to gauging its impact:

 The identification problem: As with movements in all prices, the impact of rising oil prices on the economy depends heavily on whether the source is a demand shock or a supply shock. Whereas a robust booming expansion that requires copious amounts of oil leads to both strong growth in GDP and rising prices (e.g., the 2000s expansion), a negative shock to the oil supply that boost prices and damps consumer purchasing power will weigh on GDP growth even as prices move higher (e.g., 1973,1979, 1990).

 Speed kills: Economies are able to absorb all sorts of shocks without being pushed off course as long as they are given time to adjust. Even a large supply shock that raises the price of oil significantly will not necessarily shortcircuit an expansion as long as the shock is introduced gradually. Oil shocks transfer wealth from oil consumers to oil producers and sharp and quick movements will likely generate a far larger drop in consumers’ marginal propensity to spend (MPC). If spread over longer periods, the consumers’ ability to adjust and producers’ investment response will tend to moderate the growth effects of this income transfer.

 Collateral damage: Oil price shocks are often related to factors that magnify their impact. In particular, the link of price spikes to geopolitical events has regularly amplified shocks through tightening financial conditions and weakening confidence. Similarly, oil price shocks have often reinforced existing pressures on inflation that prompted monetary policy tightening around the time of the shock.

Structural change lessens the blow

Along with these contextual factors, we highlight two structural changes to the global economy that generally lessen the blow from a given supply shock to oil relative to past experience.

 This is not your grandfather’s economy. The 300% surge in the price of oil in 1973 in response to the OPEC supply shock occurred in a global economy that was far more oil intensive than today’s. Global oil intensity peaked in the early 1970s, with every $1,000 of global GDP (in constant USD terms) requiring nearly a full barrel of oil (Figure 2). Energy efficiency has increased markedly since that shock—indeed partly in response to that shock.

 The Fed is your friend. The anchoring of inflation expectations by many large central banks, alongside recognition that sharp and quick oil price swings depress demand, has altered the way the Fed and other central banks respond to oil price shocks. Indeed, since the late 1980s, the general pattern has been for Fed policy to ease into supply shocks generating oil price shocks (Figure 3).

Modeling a negative oil supply shock

With the above nuances in mind, we turn to a simple general equilibrium model that attempts to address the identification problem directly while embedding empirical estimates of the relationships between activity, supply, and demand in the developed and emerging market regions over the past two decades. While simple, this model aligns well with more sophisticated commodity-impact models used by the IMF. Solving for the model equilibrium provides an extremely useful set of “elasticities” showing the impact of demand and supply shocks on both GDP growth and oil prices (Table 2; see appendix for model details).

For the current exercise, we consider a quick (i.e., over one to two quarters) 100% jump in the price of oil (Brent) from its 4Q20 average of $75/bbl to $150/bbl that owes entirely to a supply shock. We estimate that such a supply-induced jump would require a 2.3mbd cut in the oil supply (roughly a 2% drop in total global supply). Based on the model elasticities from Table 2 above, a supply shock that pushes the price of oil to $150/bbl would damp global GDP by 1.6%-pts. Assuming this adjustment in GDP took place over two quarters, the impact would amount to a 3.2%-pt drag at an annualized rate that would push the global economy to a near stall given our forecast for roughly 4% ar global GDP growth over 1H22.

While the DM is generally more adversely impacted by rising oil prices (from supply shocks) the reduced-form net impact on the EM is larger given the EM’s linkage to DM growth.

The model is useful because it accounts for all endogenous responses. Specifically, the 100% oil price supply shock considered here would damp DM GDP by 1.4% and EM GDP by 2%. If the adjustment took place over two quarters, the annualized drags on growth would be twice as large.

With regard to inflation, the impact from a 100% jump in the price of oil would be considerable. Global headline inflation is currently running at a multi-decade high over 6%ar. The correlation between the price of oil and headline consumer prices is quite strong and suggests a 100% surge in Brent over three months would boost global CPI by roughly 2%-pts (Figure 4)—an impulse that would boost global inflation by an annualized 4%-pts annualized in 1H22. It is largely the purchasing power squeeze from this jump in consumer prices that would weigh heavily on consumer spending and generate the drag on GDP from the model above.

A challenge for central banks

Central banks’ reaction can either cushion or exacerbate the impact of a large jump in oil prices. Over the past three decades, DM central banks led by the Fed have been inclined to see supply shocks boosting inflation as a drag on growth that should be cushioned. However, with inflation running high and policy stances having yet to normalize, there will be considerable concern related to insuring that inflation expectations remain anchored close to targets. Pressure on EM central banks to act to anchor inflationary expectations is likely to intensify. With global risk appetite diminishing and EM oil consuming nations facing widening current account deficits, depreciation pressures will also emerge.

Houses and Holes

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