In 1978, a revolution began in Iran that resulted in the Shah fleeing into exile the following year, during which time the new regime fermented trouble with the US culminating in the occupation of the US embassy in Tehran. The year 1979 was when Saddam Hussein gained dictatorial control of Iraq and protests gripped Saudi Arabia. Oil prices more than doubled from 1979 to 1980 in what became known as the second oil shock of 1979-80. Inflation in the US was 9% by year end, forcing new Federal Reserve Chairman Paul Volcker to raise the US cash rate from 11% to 19% from 1979 to 1981 to purge it. The economic cost was, at the time, the most severe US recession since the Great Depression.[2]Since the oil shocks of the 1970s, oil prices have spiked just about every time a crisis blazed in the Middle East. Prices jumped when Israel invaded Lebanon in 1982, after Iraq conquered Kuwait in 1990 and during the subsequent Iraq War of 1991 and around the US-led invasion of Iraq in 2003. They climbed whenever violence intensified during the two Palestinian Intifadas or uprisings of 1987 to 1991 and 2000 to 2005. They surged to a record high of about US$147 a barrel in 2008 when tensions surrounding Iran’s nuclear program and unrest in oil-producing Nigeria and Venezuela coincided with strong global growth.

Oil prices have responded to political volatility in the Gulf because 66% of the world’s known oil reserves are located in the Middle East Opec member countries; namely Iran, Iraq, Kuwait, Saudi Arabia, Qatar and the United Arab Emirates.[3] Often, oil prices would jump, almost irrationally on any flare-up around the globe, even if non-oil producers were involved, because they were treated as a bellwether of global instability.

In recent months, Russia, the world’s third-biggest producer of oil, has tussled with the west over Ukraine. The US military re-engaged in Iraq to fight Islamists after they seized about one-third of Iraq, a country that has 12% of Opec’s reserves, having already gained control of about a third of neighbouring and oil-producing (but non-Opec) Syria. Libya, with 4% of Opec’s reserves, descended into deeper chaos for the most part. For the third time in six years, Israel attacked Gaza, which is allied with Qatar, where 2% of Opec’s reserves lie. How much did oil prices jump during this turmoil, a time when global purchasing managers indices pointed to stronger global growth? Well, they fell. To the surprise of many, the US benchmark West Texas Intermediate dropped below US$100 a barrel in August – and fell as low as US$91.66 on September 1, its lowest in seven months – from an average of US$106 in June, while Brent Crude, which is the basis for what Europeans pay for oil, was at a 16-month low in early September when it dropped to US$100.34. Why? Largely due to the shale revolution in the US. A 55% surge in US oil production over the past six years that has boosted US output to about 10% of global production appears to have changed the supply-demand dynamics of global oil markets enough to weaken the sway the Middle East holds over prices as the so-called swing producer, a dynamic that is largely due to Saudi Arabia’s ability to alter production. The drop in oil price – and the resulting absence of any dent to US consumer spending – is one of the reasons why global stock markets withstood the crises of recent months. Indications are that the US shale revolution will help insulate the global economy from political upheavals in the Middle East in coming years.

Oil prices in July and August might well have been lower if the Middle East had been calmer. Not all the recent decline in oil prices is tied to the US shale revolution. Oil prices also slid because Libya in July reopened an oil-exporting port that had been closed by rebels for 12 months. As well, Washington’s decision to bomb the Islamic militants in Iraq reduced the political risks to Iraq’s oil industry. The Islamists in their self-declared caliphate are selling cheap oil from captured wells, as are the Kurds from their autonomous part of Iraq. More longer term, greater fuel efficiency and a switch to renewable energy are reducing demand for oil, so it’s not just shale lowering the price. Events in the Middle East could always spiral out of control enough to boost oil prices, no matter what US shale-related production might be, especially if Iraq’s southern oil fields were captured by Islamists or Saudi Arabia became unstable. (Don’t rule it out.) Ructions elsewhere could ignite oil prices, especially in Ukraine. The growing appetite of the emerging world, especially of China, for Middle East oil could rejig the demand-supply equation more in favour of Opec. Still, the decline in oil prices in July and August shows the US shale revolution is insulation against Middle-East turbulence these days. This gives investors one less worry when they scan the risks ahead.

The last resort

The US shale revolution came about because mining engineers worked out that horizontal drilling and hydraulic fracturing (or “fracking”) allowed them to extract the oil and natural gas that are trapped in layers of sedimentary rock. While there are large shale reserves around the world, only in the US was the extensive pipeline infrastructure, technical know-how, ample water and favourable tax and regulatory regimes in place to enable the new technology to be exploited.

Thanks to fracking, the US arrested years of declining oil production and boosted output enough to become a net exporter of refined oil products for the first time in 60 years[4] – franking is even leading to the end of the ban on crude oil exports in place since 1975 as exceptions are being allowed.[5] Statistics from the US’ Energy Information Administration show that US crude oil production averaged 8.5 million barrels per day in July this year, the highest monthly output in 27 years and about 3.5 million barrels a day more than in 2008. The statistical arm of the US Energy Department expects US crude production to reach 9.3 million barrels a day in 2015, a prediction that, if fulfilled, would represent the highest output since 1972.[6]

All this extra production reduces the US’ reliance on imported oil and often forces Opec and other oil-exporting countries to discount in their search for replacement markets. The surge in US domestic production cut US oil imports to 7.17 million barrels a day of crude in May this year, a 26% decline from six years earlier. The share of US petroleum needs met by net imports dropped to 33% in 2013 from 60% in 2005. The Energy Information Administration “expects the net import share to decline to 22% in 2015, which would be the lowest level since 1970”.[7]

The US motorist is enjoying the benefits of the US shale revolution. Petrol prices fell 8 US cents a gallon (or 3.2 US cents a litre) to US$3.61 in July from June, as global oil prices slid. (Did you notice how cheap petrol has been in Australia lately?) The Energy Information Administration is predicting retail prices to decline to US$3.30 a gallon by December, a prediction that is all the more surprising because demand for crude in the US is at a record high. In April 2014, US demand for petroleum products was 187,000 barrels a day higher than a year earlier thanks to faster economic growth fanning activity.[8]

The ones you can rely on

Wondering why global stocks as well as US equities benefited from these lower US petrol prices? The answer is that US consumers still play the most pivotal role in the world economy.

Investors everywhere prioritise tracking the US economy because the US citizen is what economists refer to as the world’s “consumer of last resort”. If you take the term literally, it means that companies can always export their produce to the US if people elsewhere aren’t spending. While that’s an obvious exaggeration, the term is a salute to the importance of the US consumer to the world economy. US private consumption typically accounts for close to one-fifth of global GDP. Economists estimate that pre-2008, when the US consumers were on a spending binge, a one percentage point increase in US growth typically boosted global growth by about 0.4 percentage points.[9]

The US has been the world’s biggest consuming country ever since it became the world’s largest economy with most of the world’s richest people, something that dates to the aftermath of World War 1. Perhaps the days of the US being the world’s biggest economy will pass but, even so, it will take longer for its role as the consumer of last resort to fade. It’s certainly true, though, that the US role as booster of global growth has dimmed a little. Three decades of rampant capitalism and the battering from the global financial crisis on employment and wages have reduced the relative spending power of the middle and lower classes in the US. Demographic changes mean the all-consuming baby boomers have moved on from the times in their life where their spending was at its maximum.
Maybe in a few decades Asia’s expanding middle class will take over the distinction of being the world’s consumer of last resort. But until then, it will be US consumers who hold sway over the world economy and global share markets. And investors will analyse events, including those in the Middle East, more for their impact on the US consumer than on anything else.
by Michael Collins, Investment Commentator at Fidelity