With oil prices dropping there are clear winners and losers, but the financial markets are in turmoil.
One of the most striking developments in 2014 was the near-collapse in international oil prices during the second half of the year. After having traded steadily in the 100-120 dollar/barrel range since 2011, the benchmark Brent crude oil price has been on a virtually constant decline since July last year, and has broken below 50 dollars/barrel.
Prices at these levels are not unprecedented. Oil was at 50 dollars/barrel as recently as 2009, and history – certainly since the first oil crisis in 1973-74 – is full of episodes of big moves in international oil prices.
Like anything else in a free (or semi-free) market, oil prices reflect demand and supply. Demand for oil and other energy sources has seen a more moderate expansion ever since the onset of the “great recession” in 2008, particularly as the relatively energy inefficient emerging markets experienced significant declines in growth. During the same period, global energy production increased substantially, particularly due to the shale gas revolution in the United States.
If anything, it is surprising that oil prices remained so high all the way until mid- 2014, but many market participants kept hoping Saudi Arabia would announce cuts in oil production – that is, to act as the ‘swing producer’ as they used to do. And while markets waited for such a move, prices stayed high, encouraging further energy production by more marginal producers – with excess supply going into storage. Eventually, as global demand for energy eased further during last summer, international oil prices eventually began to soften. When OPEC, which produces about 40% of global oil, at their meeting in November decided to keep output unchanged, there was only one way for oil prices to go, namely down at a very rapid pace.
While forecasting oil prices is a fool’s game, it seems safe to say that a rapid and substantial reversal in prices seems unlikely. The global recovery is too gradual to fuel a strong increase in demand, and while prices have dropped below the marginal cost of production in many areas, shutting down production is also expensive and will come only slowly. A more abrupt cut in supply would have to come from a geopolitical disaster in the Middle East or a political decision by Saudi Arabia, but neither options feature in mainstream forecasters’ scenarios. With the generally agreed outlook of continued relatively low oil prices, it is surprising to see financial markets – and many commentaries – so confused about the implications. We have plenty of history and statistics on which to base our predictions of what this latest collapse in oil prices means for headline inflation, real income and for specific asset classes.
A decline in oil prices implies a reduction in the ongoing transfer of income and wealth from users to producers. On the country level, this means that Western and Central Europe, several emerging markets and (to a lesser extent) the US will be beneficiaries of the lower oil prices, while oil producers like OPEC, Russia, Indonesia and Norway will be losers from the lower prices. In Europe (and the US), the key beneficiaries will be households, which are now enjoying an increase in their real income that they have distributed equally between additional consumption and a restoration of previous years’ savings ratios. Non-oil related businesses also benefit – from the lower energy prices and from the higher demand from households. This is a win-win situation, which should bode well for the economic recovery and equity markets.
Yet, so far, markets seem confused because of excessive concern about possible damages to the economy stemming from the decline in inflation, which has now turned negative. In other words, inflation has turned into deflation. Such concern is misplaced. Deflation is damaging only when it is the result of widespread insufficient demand for goods and services relative to supply and if it becomes a self-fulfilling development because people and businesses begin to delay purchases in anticipation of still lower prices. In contrast, deflation is a positive when it stems from an import price shock, such as a decline in oil prices, that fuels an increase in real income, as we are now witnessing. And the downward pressure from lower oil prices on overall inflation is temporary. For oil prices to keep pushing overall inflation down beyond one year, one needs oil prices to decline at an ever-faster clip — hardly a likely scenario.
Among the oil-exporting countries, one needs to differentiate between those with strong savings balances (e.g., in the form of big wealth funds, such as Saudi Arabia, the smaller Gulf states and Norway), which will come through the present price drops in fine form. In contrast, countries such as Russia, Iran and Venezuela, which live mostly off the cash flow of energy production, are already struggling with the new reality of lower oil prices.
The Russian GDP will contract significantly this year, increasing the corporate sector’s financing needs. With sanctions blocking their access to Western financial markets, the central bank has begun to step in and provide dollars and euros to the struggling corporate sector. However, there is a clear limit to how long the central bank can play this role.
Unless oil prices bounce back very soon, the Russian corporate sector faces a very difficult 2015 and 2016. Sanctions may, of course, be lifted around mid-year, but even a political restoration of access to financial markets will only lead to the needed financial flows if trust is restored also among foreign investors. For that to happen, economic reforms to liberalise the economy and make it less energy dependent will be key.
With oil prices dropping there are clear winners and losers, but the financial markets are in turmoil.
