Are Low Oil Prices Really Good? by Filipe R. Costa

by Filipe R. Costa

We are all amazed with current oil prices, in particular when we go to the filling station. Lower oil prices (even if we take into account the declines in the pound and the euro) mean lower energy prices in general, which seems to be a good thing. But when prices decline too much and too quickly, they reflect an underlying condition that is not good at all.

Lower oil prices are the result of an equilibrium of forces that range from price wars between suppliers to declines in global demand. In general, when supply is stable, oil prices start to decline quickly as the result of declining demand, which usually comes from out of favour economic conditions. On the other hand, if demand stays unchanged, a declining price can also be the result of increases in supply levels or derived from some kind of price war between producers.

Currently we have both situations.

Demand is faltering while suppliers are having a price war, as OPEC members try to regain market share that has been lost to outside producers, including to those shale oil producers in the US.

When fracking technology was adopted and applied to shale oil drilling a new world was opened to US oil exploration. The country’s oil output hit 8.95 million barrels per day in the week to 10th October, a 29-year high.

This was only possible due to three main events: 1) the discovery of a new technology; 2) high oil prices; and 3) the near zero cost of money. While the new technology is here to stay, the same isn’t true about high oil prices and the low cost of money. If we also take into account that global demand for oil is sinking, as predicted by the Energy Information Administration, then this nascent industry in the US will be under serious trouble.

OPEC countries have always been in control of oil prices but this time they aren’t moving that quick in order to cut production and put a floor on the price because they want to get rid of the extra competition they now have. Although many analysts estimate that OPEC countries may run into fiscal deficits if prices are kept at these levels, the core OPEC countries are so strong in terms of their net debt positions that they can very well allow for negative budgets for two or three years, without running into fiscal trouble.

With this in mind, I really doubt they will do much, as that would be more favourable for shale production and competition coming from other countries like Russia, than for the core OPEC countries. Oil prices are down between 25% and 30% so far this year and the EIA expects them to decline even further at least until early 2015.

I foresee severe problems to come, at least in some particular markets.

Russia, for example, is already in big trouble, as two thirds of its exports come from the energy sector. The Russian Central Bank has already cut its economic predictions, estimating GDP growth of 0.3% this year and 0% next year. But those predictions assume much higher oil prices than are currently seen in the market. If oil prices are kept around $80 a barrel, Russia will most likely show a GDP fall of around 1.7% in 2015.

The Russian ruble has been under heavy attack as investors are realigning their portfolios, getting rid of Russian equities. The Russian Trading System index is down almost 30% in 2014 while the S&P 500 is up by 10%. Over the last month, global markets bounced back from lows to regain strength but the Russian market still declined more than 5%. Of course, the conflict with Ukraine also plays a role here, but oil prices are a key driver for the future of the Russian economy and its financial markets, and at this pace, the country will experience severe trouble.

To avoid a situation similar to what happened to the Bank of England in 1992 when George Soros “broke” the bank, the Central Bank of Russia had no other option than to raise interest rates from 5.5% at the beginning of the year to the current 9.5%, as there wouldn’t be enough reserves to face the outflows. Nevertheless, it was not enough to prevent the ruble from depreciating by 40% so far in 2014.

At the same time, the rise on key benchmark rates will just contribute to a further deterioration of economic conditions within the country and increase the odds for further GDP growth downgrades. With growth estimated to be barely positive under the current scenario (a very optimistic one), if oil prices continue to decline, the country will face a heavy recession.

READ MORE OIL PRICE ANALYSIS IN THE NOVEMBER EDITION OF SPREADBET MAGAZINE