Global Implications of Oil Prices & Trade Imbalances

Oil prices have a major influence in determining global economic stability and shaping the dynamics between countries with varying political systems.

The relationship between oil-exporting nations and the rest of the world not only affects trade balances but also carries significant implications for geopolitical power and financial flows.

In this article, we’ll look at the global implications of oil prices and how trade imbalances and the resultant financial flows between countries influence economies, geopolitics, and markets.

Key Takeaways – Global Implications of Oil Prices (Money & Credit Flows)

• Oil Price Impact on Trade Balances – Oil price changes significantly affect global trade, with rising prices burdening net importers and benefiting exporters.
• Geopolitical Influence of Surpluses – Countries with large surpluses, like oil exporters and China, gain geopolitical power through their financial activities.
• Autocracies vs. Democracies – Autocratic and democratic nations differ in how oil impacts their economies. This impacts global politics and economics.
• Investment Complexity – Tracing money and credit flows is challenging due to complex, non-transparent financial structures.
• Vulnerability to Shocks – The global financial system is sensitive to geopolitical tensions and economic shifts, which is influenced by the oil market and when trade imbalances between surplus and deficit countries is high.
• What This All Means for Traders & Investors – We cover some take-home points for markets toward the end.

Below we look further at what goes into it:

Trade Imbalances

Oil price fluctuations have a material impact on global trade balances.

When oil prices rise, net importers – like most European nations and most countries, in general – face higher energy costs.

This pressures their current accounts and potentially leads to stagflation – a combination of stagnant economic growth and high inflation.

On the flip side, net oil exporters such as Russia and certain Middle Eastern countries experience the opposite.

Based on different models, a 1% positive real oil price shock results in an up to 0.11 percentage point improvement in current account balances of oil exporters and an up to 0.07 percentage point deterioration for importers (source: World Bank).

This influx can embolden their foreign policy maneuvers, and increase political tensions.

Impacts for Oil Exporters

The magnitude of this improvement can vary significantly depending on:

• Oil dependence – Countries heavily reliant on oil exports will see a larger impact than those with diversified economies.
• Production levels – Countries with higher production volumes benefit more than those with lower volumes.
• Spending patterns – How the additional revenue is spent (e.g., reinvesting in oil production, importing goods) affects the final impact.

Impacts for Oil Importers

Similar to exporters, the magnitude of this deterioration can vary depending on:

• Oil dependence – Countries heavily reliant on oil imports will be more affected than those with diversified energy sources.
• Consumption levels – Countries with higher oil consumption will experience a larger impact.
• Economic resilience – Countries with strong economies and flexible exchange rates may be able to absorb the shock better.

Autocracies vs. Democracies

Today, you increasingly see a geopolitical split between autocratic nations like China and Russia and democratic societies in the US and Western Europe.

Authoritarian regimes often channel their oil revenues into consolidating power, expanding their military capabilities, and extending their global influence.

Conversely, democratic states are in a balancing act where they have to weigh economic necessities against human rights considerations and geopolitical stability.

For Western democracies with large oil revenues – take Norway and Canada as examples – Norway invests its oil revenues in a sovereign wealth fund for future generations, while Canada uses its for government spending and some regional investment.

Tracing the Money Flow

Tracking global money and credit flows isn’t easy due to complex financial instruments and havens obscuring the trajectory of these flows.

While surplus nations historically finance those in deficit, the paths these funds traverse get more intricate and less transparent over time.

Example

Imagine a Chinese State-Owned Enterprise (SOE) in the energy sector seeks to invest in a foreign oil field.

Here are two possible scenarios:

Scenario 1: Direct investment

The SOE directly invests in the exploration and development of the oil field.

This makes its involvement clear and transparent.

Public records and company reports would detail the investment and its progress.

Scenario 2: Layered investment structure

The SOE creates a series of subsidiary companies in different jurisdictions, each with varying levels of ownership opacity.

These subsidiaries then:

• Establish a joint venture with a local company in the oil-producing country, which obscures the Chinese SOE’s direct involvement.
• Use opaque financial instruments like derivatives or special purpose vehicles (SPVs) to channel funds into the project.
  • This makes it difficult to trace the origin of the money.
• Hire third-party contractors for key aspects of the project.
  • This further distances the SOE from direct activities.

In this scenario, tracking the SOE’s involvement becomes challenging:

• The ownership structure of the subsidiary companies and joint ventures might be complex and difficult to untangle.
• The use of opaque financial instruments and third-party contractors creates layers of obfuscation.
• Publicly available information may not reveal the full extent of the SOE’s involvement or its ultimate goals.

This highlights how complex investment structures can be used to shield the activities of various entities globally.

This makes it difficult for stakeholders to understand their true intentions and potential impacts.

It also makes the jobs of policymakers and sophisticated market participants harder when they don’t have this information.

Money and credit flows are ultimately what affect prices in the markets, and absent this data, it’s hard to know exactly what’s going on.

Geopolitical Shocks

Geopolitical instabilities can create abrupt disruptions in the oil market, which can lead to price spikes and economic shocks to oil importers.

These disturbances can affect currencies, stock markets, and the availability of credit.

Taiwan Tensions

A hypothetical scenario where China annexes Taiwan while retaining its international reserves seems highly unlikely.

(A reserve is basically a foreign bond or financial instrument that represents a promise to pay. The US, for example, could unilaterally choose not to pay China’s holdings of US Treasury debt if relations were to get bad enough.)

Such aggressive action would provoke sanctions, prompt capital flight from China, sever China’s economic ties with the Western world, and severely hamper its access to vital resources and markets.

This scenario would significantly disrupt the oil market.

Would China still consider military action in Taiwan given it’s aware of the response from other countries, and potential escalation into a broader war?

Generally, national security interests come before economic and financial interests, so how China views Taiwan from all perspectives isn’t known.

National Security vs. Economic Interests

While safeguarding strategic interests is of utmost importance, complete economic disengagement from major global players like China is generally impractical due to the extensive interconnectivity of today’s world.

Strategies for reducing these risks include diversifying energy sources, forging stronger strategic partnerships with allies, and enhancing cybersecurity measures to protect critical infrastructure.

While there’s a push for renewables for environmental and national security reasons, in many ways it’s still aspirational and oil will remain a critical commodity for the foreseeable future.

Emerging Economies and the Surge in Surpluses

China’s surplus and the growing surplus of oil-exporting countries highlight the significant build-up of global foreign exchange reserves.

Many emerging markets still actively intervene in foreign exchange markets, which can suppress currency appreciation.

This benefits exporters but potentially harms competitiveness and can produce domestic inflation by not being open to the cheapest goods and services, wherever they might happen to come from.

The rise in foreign reserves influences global financial flows and potentially raises geopolitical tensions.

This activity, along with the large surpluses from oil exporters and China, has changed global financial flows and increased the geopolitical influence of these countries.

‘Balance of Financial Terror’

The term “balance of financial terror” describes how China kept financing the United States despite a clear degradation in the latter’s financial conditions (expenses above revenue, liabilities above assets), which highlights how closely global economic stability is linked.

The dependence on artificial safe assets and the large money flows from countries with surpluses to fund those with deficits makes markets prone to disruptions from economic and political events.

If such funding were to be reduced – i.e., creditor surplus countries less likely to fund debtor deficit countries – this would put more stress on deficit countries to have their own central banks buy the debt created from their deficits.

This, in turn, would put devaluation pressure on their currencies and create more inflationary pressure.

Geopolitical Shifts and Financial Opacity

The shift where autocratic surplus countries, like Russia and China, are no longer adding to their formal foreign exchange reserves introduces an extra layer of complexity.

This change (particularly in the context of Russia’s frozen central bank assets and Saudi Arabia’s choice to diversify its investment strategy away from traditional reserves) indicates a transformation in how these surpluses are managed and deployed.

Also, the increased opacity in tracking global flows (made worse by the complicated web of financial intermediaries and the strategic financial decisions of surplus countries), makes understanding and predicting the implications of these imbalances more challenging.

This obscurity in financial flows, combined with the not-fully-known geopolitical strategies of surplus nations, adds unknowns to the global economic and political order.

Implications for the Global Economy and Trade Dynamics

The realignment of global surpluses (with its significant concentration in autocratic regimes) is an interesting contrast in the global trend toward deglobalization and “friend-shoring.”

The hypothesis that trade will become more fragmented (“trade wars”), with democracies trading among themselves and autocracies doing the same, is contradicted by the current pattern of trade imbalances.

If one group of countries has surpluses (and these are heavily concentrated in autocratic countries) and another group has deficits (democratic countries, by and large), there needs to be a balance via financial flows between them, by definition.

The reality that the world’s significant autocracies are collectively running a record trade surplus while not actively seeking to bolster their dollar reserves is a unique trend that challenges conventional thinking about global trade dynamics.

Instead, they’re diversifying more into gold, Chinese renminbi, and the stocks, bonds, and real estate of other countries.

What This Means for Traders & Investors

From the analysis, traders/investors can derive several strategic and tactical asset allocation decisions from the set of circumstances:

Diversify Geographically

Given oil’s impact on trade balances, diversifying investments across countries/regions helps to mitigate risks from oil price fluctuations.

This is especially true considering the different effects on net importers versus exporters.

Be Aware of the Risks of Debtor Deficit Countries

For those who are US- or Western Europe-based traders/investors, there’s a tendency to concentrate allocations in the stocks, bonds, and other assets relevant to these regions.

This concentration can expose portfolios to greater risk if debtor deficit countries face financial distress or significant currency devaluations, which highlights the importance of geographic diversification.

Monitor Geopolitical Developments

Be aware of geopolitical shifts, particularly in oil-rich autocratic (including China) versus democratic regions, to anticipate potential risks and market movements.

Assess Risk in Complex Investments

Be cautious with investments in regions or sectors with opaque financial structures.

Recognize the higher due diligence required to understand risks, exposures, and rights as a stakeholder.

Volatility

Given the oil market’s sensitivity to geopolitical tensions and economic shifts, maintain wide diversification in asset allocation to avoid acute portfolio sensitivities (e.g., strong bias toward higher growth, low inflation, and low interest rates, like most portfolios).

Consider Long-Term Implications

Strategic partnerships between allies and diversification of energy sources, as well as the greater geopolitical influence of surplus countries, suggest long-term trends that could reshape investment landscapes.

Naturally, we tend to think of what worked in the past to inform what will do best in the future.

Things nonetheless change, and we have to be aware of things in our portfolios that may be optimized based on the past but may be suboptimal going forward.