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Low Oil Prices are More Fuel than Foul

Courtesy of Russell investments.

Since mid-2014, watching the price of Brent crude oil has been like watching a falling rock. From USD $115 a barrel in June 2014, to $80, then $60, then to under $50 as of January 16, 2015, it has been a dramatic plunge. For the most part, this is very good news for the global economy. But there are a few caveats – a swing this sharp and rapid can be unsettling, to say the least.

First, why the big drop? Part of it comes from the fact that economic growth in Europe is slow to non-existent, and slowing in Japan and China. In our view, the price drop could be due to lower demand than forecasted. For the rest, we can most likely thank high production. New technologies to extract oil from shale in the United States and Russia have left those countries awash in the black stuff. Meanwhile, big producers such as Saudi Arabia are not cutting back for fear of losing market share and out of frustration that higher cost producers are not exercising output restraint.

The result is a huge transfer of wealth from oil producers to oil consumers. Australia – one of very few developed countries that is a net energy exporter – takes a pay-cut, as prices of key exports such as coal and natural gas are dragged down by the downdraught in oil, and in energy overall. New Zealand, in contrast, is better placed. Despite being an exporter of high-grade oil, and being a significant producer of renewable energy (e.g. hydro and thermal), New Zealand is a net importer of oil. Internationally, in the wake of the oil price collapse, dollars that would have gone into sovereign wealth funds in the Middle East or Norway will likely go to consumers in the United States, Japan and Europe. That’s important, because as Bloomberg Businessweek pointed out recently, consumer spending accounts for around 60% to 70% of spending in mature economies such as the US, Australia and NZ. So oil-using consumers there and elsewhere will likely see wads of dollars, euros or yen put into their pockets. Automakers, airlines, big fleet operators such as FedEx® – all may benefit as well. Inflation interest rates around the world are being driven relentlessly lower by the impact of lower energy prices and the pervasive flow-on effects. Here at Russell, we’re not concerned about the implications of these deflationary developments. Lower energy costs constitute the kind of deflation economies like.

If there’s a darker side to this, it’s the sheer rapidity of oil’s descent. In our experience, there are entities around the world that are likely under enormous pressure from oil’s drop, either because they hold debt they hoped to pay off with oil dollars, or because they have derivative positions. These entities may turn out to be companies, lenders or even whole countries. For the most part, no one knows yet who’s really exposed – “swimming naked”, as Warren Buffett likes to say – and the impact on them when their exposure is eventually revealed. Such a situation can create uncertainty in markets, and markets hate uncertainty. The swings in US stocks over the past few weeks can be explained in part by this lack of transparency into cheap oil’s casualties.

Declines in oil prices have already impacted the energy sector in the Australian equity market significantly. The energy sector, as at mid-January 2015, is off its 2014 highs by around 25% - 30% — compared to only a 5% drop for the market as a whole. On the plus side, the weaker inflation backdrop associated with falling oil, has seen a renewed appetite for Australian and NZ bonds – both of which are relatively 'high yield' by global standards. Yields in both countries have fallen precipitously in recent weeks. Cheap oil also has geopolitical consequences on oil producing countries. Expensive oil made Russian President Vladimir Putin arrogant. Cheap oil likely is making him frightened, which could be even worse. Who knows what mischief could be caused by a Russia with little to lose? Cheap oil also puts enormous strain on Venezuela, and could further destabilize an already fragile Middle East.

Nonetheless, go ahead and raise a toast to cheap oil. But don’t overdo it – this respite won’t last forever and may yet cause a few difficulties we can’t foresee.

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