Michael Karagianis

The winds of change are blowing across the Middle East as citizens across the region rise up in protest against their governments and ruling families.

The winds in Libya and Bahrain in particular are sending shivers down the spines of Western governments. What makes the recent developments in these countries (as opposed to Egypt and Tunisia) more significant for the West is the significance of these countries to the flow of oil.

Prior to the outbreak of civil war, Libya was producing around 1.6 million barrels per day of oil, of which around 1 million bpd was being exported primarily to the European market. That makes it a moderate oil producer in the region.

Bahrain is a relatively small oil exporter. Of much greater strategic significance is Bahrain’s close alliance with its neighbour Saudi Arabia. The closeness of the two countries, geographically, strategically and demographically, makes the current strife in Bahrain particularly worrying for the West.

Saudi Arabia is the largest oil producer in the world at just under 9 million bpd and, at its current rate of production, still has a further 80 years before its known reserves would be exhausted. That makes Saudi Arabia economically and strategically vital to the West.

And, given their similarities, what happens in Bahrain potentially represents the ‘thin end of the wedge’ for the House of Saud. If the Bahraini ruling family were to be toppled by a popular uprising then what might stop the Saudis experiencing a similar fate?

Not surprisingly in the face of this turmoil, oil prices have surged over recent months as events have unfolded. The benchmark Brent oil price has risen 36 per cent from US$ 85 bbl (per barrel) at the end of November 2010 to US$117 bbl as of 5 April 2011.

The actual disturbance in the supply of oil to the West has been moderate thus far with significant opportunity for other OPEC states to increase production to make up for any shortfall. However, the rise in the price of oil has as much to do with the potential threat to global supplies if Middle Eastern instability were to extend to Saudi Arabia.

Saudi output represents approximately half of the daily consumption needs of the US or about the total oil demand of China. Any actual disturbance to Saudi oil supplies or even an increased threat to them could send oil prices sky high.

The magnitude of the rise in oil prices thus far, if maintained long enough, could modestly undermine global GDP growth in 2011 and would temporarily boost inflation measures. It would be unlikely however, to undermine the global recovery currently underway and the moderately positive outlook for global equity markets.

However, a worst-case outcome, which saw oil prices rise a further 40-50 per cent, would have a significant and depressing effect on growth in developed economies if sustained for any length of time. This scenario would likely have a negative effect on global equity markets with higher investor risk aversion and lower earnings expectations undermining expected returns.

Overall, this seems a less likely scenario, but it is not one that can be truly discounted given the twists and turns of Middle Eastern politics.

However, equally we should not discount a more benign scenario, which sees these winds of change blow themselves out over coming months as tensions ease naturally.

What the rise in oil prices in recent months has done to strip investor confidence could easily be handed back in a scenario of oil prices reverting to $80-85 bbl on easing tensions in the region.

The sheer unpredictability of the events in the Middle East and Japan in recent months highlights the importance of investors maintaining well diversified portfolios that aim to reduce not just the possible impact of foreseeable risks on their returns but also those risks that by their nature are completely random or unexpected.

Michael Karagianis is an investment strategist at MLC Investment Management.