By Buczynski, Rick; Molavi, Justin
The RMA Journal
Certainty is the mother of quiet and repose, and uncertainty the cause of variance and contentions.
--Edward Coke, English jurist and parliamentarian, 1552-1634
If you're as old as one of the authors of this article, you'll recall the twin oil crises of 1973 and 1979 that led to long lines at gas stations. Juxtaposed to an otherwise anemic, inflation-riddled economy, these oil shocks ushered in a decade of high unemployment with indecisive, if not ineffective, government policies. (Recall the "WIN"--Whip Inflation Now--mantra.)
In recent months, political tensions in the Middle East and signs of a sustained global economic recovery have raised concerns that crude oil prices could spike as they did in mid-2008--with consequences similar to those of the oil-shock decade.
Bankers are wondering about the effect such an outcome would have on portfolio quality, and regulators are fueling their angst by insisting, in many cases, that banks undertake a "sensitivity analysis" to determine the effects of $150-per-barrel oil on their portfolios.
Although we don't believe we'll revisit a calamitous era akin to that endured in the 1970s, (1) several of our IBISWorld banking clients have expressed interest in the potential risks and opportunities that $150per-barrel oil could bring. In essence: What are the correlations between crude oil prices and industry performance and risk?
Sensitivity or Scenario Analysis?
Although single-factor sensitivity analysis has some merit, it can lead to horribly misleading results and serious errors in credit policy. We are not advocates of this approach.
Since oil prices carry considerable weight in determining overall prices and economic activity, it would be imprudent to undertake a study devoid of the interrelationships between oil and other key variables. We therefore propose engineering a scenario test that endeavors to account for these interdependencies.
[FIGURE 1 OMITTED]
The common wisdom is that a scenario of $150 oil is unsustainable given the "destructive demand" argument: Higher prices undermine demand in a weakened economy, trimming the sails of hyped-up energy prices. This consequence is amplified as other nonoil commodity prices spiral up, eroding the disposable incomes of households and the profit margins of many businesses. Some bankers believe that a sustained price of $150 a barrel is inconsistent with 3% GDP growth in the U.S., thus calling into question the relevancy of running single-factor, oil-price sensitivity tests. We concur.
[FIGURE 2 OMITTED]
The Work Plan: Building a Stagflation Scenario
We'll attempt to develop a reasonable scenario based on the following sequential approach:
* Examine the fundamental relationship between crude oil prices and real GDP.
* Determine the relative strength of the relationship between oil and other key commodity prices. As mentioned, it would be presumptuous to undertake an analysis of the industry effects of a spike in oil prices while ignoring the linkages between crude and other commodity prices.
* Determine whether IBISWorld Industry Risk Ratings (2) are correlated with crude oil prices.
* Run a $150-per-barrel oil stagflation scenario using IBISWorld's 700-industry NAICS-based stress-testing model. (3)
Let's start with GDP and oil prices. While we don't profess to having a prowess to estimate the total impacts of higher oil prices on general economic performance--and the relationship is undoubtedly nonlinear (4)--this is surely a central part of the equation. According to the Federal Reserve, each $10 increase in the price of oil will trim between 0.2% and 0.4% growth from real GDP growth in America and add 0.5% to inflation.
As depicted in Figure 1, which includes our forecasts for oil prices, (5) it's apparent that, in most cases, high oil prices are forerunners of recessions. …