Realization is beginning to set in amongst the global policy making community that high and volatile oil prices are now a serious threat to the global economic recovery. Moreover, excessive fiscal deficits and very low short-term interest rates leave policy makers with few policy tools left at their disposal with which to deal with the problem.
In view of this, there must be some short-term relief that Saudi Arabia has now officially taken action in pumping more oil to replace that lost from Libyan output. This is at least helpful.
However, to focus on the immediate oil supply issue risks entirely missing the point. The question is not one of how to cope with the oil output lost from one country or another. It is about the potential destabilzation of the entire region.
It is from this perspective that developments in Libya look increasingly dangerous. There is clearly a need for the international community to take measures to aid the pro-Democracy movement in the face of the Gadaffi regime's brutal actions.
For the financial markets, the point to recognize now is that bloodshed in Libya raises the possibility that the debate over democracy across the Arab world will become increasingly inflamed. In particular, there is the risk that it will fuel Sunni - Shi'ite tensions at an increasingly unstable level. And Iran could well attempt to maneuver some advantage from this later development.
The potential for an extremely volatile situation ahead should not be underestimated. When the pro-democracy movement came to life and spread from Tunisia to Egypt and captured the imagination of ordinary people across the Arab world, it took everyone by surprise.
Indeed, that fact may well have been a very significant factor in the relatively peaceful move towards democracy in Egypt. Importantly, the pro-democracy movement also seems to have taken the more extremist elements in the Arab world by surprise. Unfortunately, the risk is that this situation may start to change. Such groupings will have had time to plan, to organize and to push their own agendas.
This is not to suggest that these groupings could possibly take control of or even heavily influence the genuine pro-Democracy movement itself. However, for the markets, it is probably necessary to recognize that as we move forward, more extremist interests could quite possibly act to inflame the situation in a number of countries. The brutal actions of the Gadaffi regime in Libya may well have made this more likely. All of this suggests that the risk is that the path ahead may well become increasingly volatile and potentially increasingly violent.
Though no-one can predict the timing of which event will be the source of the next ratchet up in uncertainty, it is not unreasonable to suggest that there are heavy risks in that direction.
Following the long rally that stocks have seen since last Autumn, it is difficult to argue that these risks have been priced in. The SPDR S&P 500 Trust (NYSEARCA:SPY) is up 25% since its August 2010 low. There is a good argument that, irrespective of the recent Saudi action, it is now time to reduce risk and be protective.
Since December in particular, I have been recommending being long a portfolio of clean technology stocks. Of course, in the end an oil crisis will bring home the need for action on both the world's addiction to oil and clean technology. However, in the short-term even clean technology stocks are exposed to the potential fall-out resulting from the increased level of overall market risk that may arise in the period ahead.
A pragmatic response seems justifiable - risk reduction alongside the inclusion of some hedges in the portfolio. Two hedges seem reasonable, given the likelihood that we will see new highs in oil prices this year - whatever the short-term reaction to more oil from Saudi Arabia.
Firstly, oil itself. ETFs are of course available on both WTI and Brent. The most liquid is the United States Oil Fund (NYSEARCA:USO) and is based on WTI. Exposure to Brent can be obtained via the less liquid United States Brent Oil Fund (NYSEARCA:BNO). It seems reasonable to see the recent action from Saudi Arabia as providing better levels at which to hedge.
Secondly, gold. For anyone not wishing to take direct exposure to oil, gold looks increasingly interesting. Exposure to gold can of course be easily obtained via SPDR Gold Shares (NYSEARCA:GLD). If the developments discussed above become increasingly unstable, gold should benefit in three ways -
- Firstly, from a general political risk premium.
- Secondly, from increasing concerns over the possibility that an oil price-related economic downturn will produce stagflation.
- And finally, as a result of the contradictory implications for quantitative easing. If the economic recovery indeed comes under threat from high oil prices, it will be very difficult for the Fed to withdraw from its current stance towards quantitative easing without risking a panic. Even with higher headline inflation numbers, could a debate be raised over a third round of quantitative easing? The Fed will be in a very difficult position. In this proves to be the case, gold may well have a lot of room on the upside.
Nothing is certain. However, that is perhaps the point. Whatever the near-term effect of higher Saudi oil output, the risk going forward is that the market is likely to be increasingly forced to price in that difficult to quantify commodity - uncertainty. Pragmatic investors should reduce risk and use what hedges are available.
Disclosure: I am long BNO, GLD.
Additional disclosure: I remain long a portfolio of clean technology stocks with a reduced level of overall exposure.