The implications of low oil prices

The implications of low oil prices

Posted on 11 September 2015

"For most of us money is more than just a way of “keeping score” as suggested by the infamous Texan oil tycoon Haroldson Lafayette Hunt."

“Money is just a way of keeping score” – H. L. Hunt
 

Oil on troubled waters…

Are falling oil prices good or bad for the world economy? What do lower oil prices mean for capital markets? Monetary policy? The effects of lower oil prices are far reaching, varied and still hotly debated. The behaviour of capital markets over the last few months in particular suggests that oil prices are widely seen to speak more of a persistent deficiency in global demand rather than an ongoing gift to those more likely to consume. This take, while consistent with a still doggedly gloomy consensus, is likely wide of the mark in our view. We explore the reasons for this in a bit more detail below.
 

Oil prices – where next?

We explored the prospects for oil prices in a clearly still oversupplied market in great detail in our article on the subject in January’s Compass (Oil: Will Saudi Arabia stay the course?) [PDF, 1MB]. These assumptions more or less hold true. Estimating the level of oversupply is a significantly more difficult exercise than much of the commentary lets on. Both global supply and demand are measured with a high degree of error and are prone to significant revision. Estimations of prospective demand and supply are further complicated by factors ranging from an ever evolving geopolitical backdrop (influencing the prospects for Iranian production) to continuing operating cost efficiencies for producers.
 
Our suspicion remains that the level of oversupply is perhaps less than that implied by current oil price levels, where traders seem more focused on some of the more apocalyptic scenarios regarding the Chinese economy rather than the still reasonably resilient demand picture. Oil prices may well remain depressed into 2016, however, assuming the worst case scenario in China fails to materialise, we may easily expect oil prices to trend higher as 2016 progresses and that smaller than suspected surplus is worked off.
 

Is lower oil good for global growth?

In spite of the above, it is worth working on the assumption that lower oil prices are here to stay – this, after all, seems to be a key component of depressed future inflation expectations and benign forecasts for the path of developed world interest rate normalisation. Interestingly a strong lagged relationship between G7 real GDP growth and oil prices would seem to suggest otherwise (the relationship between global real GDP and oil prices is still present but understandably a little weaker given the influence of oil exporting countries) – essentially falling oil prices may eventually be seen as reflationary not deflationary.
 
There is a well-established academic consensus suggesting that higher income households have a higher propensity to save than lower income households. For most of us money is more than just a way of “keeping score” as suggested by the infamous Texan oil tycoon Haroldson Lafayette Hunt. This should help inform our view of falling oil prices – perhaps somewhat simplistically; falling oil prices can represent a transfer of wealth from a minority controlling vast proportions of the world’s oil exploration and production to the many of us benefiting from the lower transportation costs among other things.
 
That this relationship is lagged by a year-and-a-half perhaps suggests that consumers are understandably cautious of spending this windfall in the first instances, but we are now approaching the time when last year’s declines should start to be seen more visibly in G7 consumption statistics. It should not just be the G7 countries that benefit either, some of the titans of emerging Asia, India and China in particular, are net importers of oil and should therefore derive significant benefits from lower oil prices. On the other side, it should be no great surprise that the countries currently looking the most fragile around the world are mostly oil (or commodity) exporters – Brazil, Russia and South Africa to name a few.
 

William Hobbs, Head of Investment Strategy, Europe

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