Soaring oil costs 'could deepen Europe’s downturn'

Europe is in a bind when it comes to oil prices.

While the looming threat of recession across the eurozone and much of the rest of the continent has prompted a decline in oil demand in recent months, the region’s oil bill has, in fact, been rising, further crimping demand and exacerbating current account woes.

Despite recent minor spikes in global oil prices due to concerns over supply disruptions from and possible sanctions on Iranian oil, Brent crude prices have largely traded within a range of $105-$115 a barrel since last summer.

But currency weakness in Europe means that while oil prices have remained broadly flat, the cost of oil imports in local currencies has soared.

According to Francisco Blanch and the global commodity research team at Bank of America-Merrill Lynch, once currency adjustments are taken into account, oil prices are now tracking close to multi-year highs in the eurozone and UK, has propelling energy costs as a share of GDP to near-record levels (see charts below).

This is particularly bad news for heavily indebted eurozone members. Greece, Ireland and Portugal are among the European nations with current accounts that are most highly exposed to oil prices. According to the BofAML report, the consequences could be severe:

European oil demand has been falling for several quarters now, and contributed to the first quarterly global fall in oil demand since the depths of the 2008-9 global financial crisis during the final quarter of 2011, according to data released by the International Energy Agency on Wednesday. At some point, declining demand should start to ease the price pressure. But there are a number of factors that could mitigate against this:

First, and perhaps most unpredictably, there is the Iran factor. EU foreign ministers are due to meet on January 23 to decide whether or not to impose sanctions on Iranian oil imports. Iran has threatened to block the Strait of Hormuz in retaliation. Iran is the second-largest crude oil supplier to Europe after Saudi Arabia, while around 20% of the world’s oil passes through the Strait. A supply disruption on this kind of scale clearly threatens a major oil shock. Perhaps a glance at the BofAML report will lead European leaders to have second thoughts about sanctions?

Second, while Saudi Arabia has tried to make reassuring noises about being able to increase production to compensate in the event of a choking of oil supply from Iran, the Gulf state, along with many OPEC members, has little incentive to see oil prices fall significantly below current levels, especially given the admission of a top Saudi official earlier in the week that the country is now aiming to keep oil prices above $100 a barreldue to spiralling public spending. While Blanch and other analysts believe that non-OPEC members can help to boost supply, much of this outlook appears predicated on an increase in output in Libya, which remains highly unstable politically, as well as other politically uncertain oil producing nations such as Venezuela, and even Nigeria, where unions have threatened to cut off production in recent weeks.

Third, European crude stocks remain at their lowest level for 11 years, meaning that restocking will be necessary, even accounting for a decline in economic activity.

Fourth, the outlook for the euro appears extremely uncertain in light of the ongoing eurozone crisis, which could result in further weakness against the dollar, keeping oil costs elevated even if dollar crude prices begin to fall.

Given the intense anxiety enveloping Europe – and indeed the global economy – at present, amid gathering fears of a prolonged and deep global recession, oil prices may not be top of the list of global economic concerns at present.

But in light of the immense potential for political and currency uncertainty and Europe’s precarious current account balances, it is a factor well worth keeping an eye on in the coming weeks and months.