Oil prices have always had a big political component, but it seems that increasingly they also have a financial, speculative one. And if this means oil stays cheaper for longer, we may be in for a very strong economic boom.
A recent paper by the Bank for International Settlements (BIS) argues that the fall in oil prices has been too steep to be justified by a fall in demand alone.
After remaining around $100 a barrel for four years, crude prices collapsed by 50% over the past six months.
On the last two occasions when oil prices fell abruptly, in 1996 and 2008, there were sizeable reductions of oil consumption. The 1996 fall was also associated with a significant expansion of production, the BIS paper showed.
“This seems to be in stark contrast to developments since mid-2014, during which time oil production has been close to prior expectations and oil consumption has been only a little weaker than forecast,” it added.
The chart below illustrates the differences:
“The steepness of the price decline and very large day-to-day price changes are reminiscent of a financial asset,” the BIS paper noted.
During the period of high oil prices, many energy companies took on debt denominated in dollars.
This is now partly to blame for the fall in oil prices, because companies have to keep production at the same levels or even increase it to be able to make the payments and maintain their cash flows.
Companies in emerging markets saw the highest increases in debt during the boom years, encouraged by plentiful liquidity combined with the high oil prices.
Now they are facing the double whammy of a stronger dollar due to the Federal Reserve’s end of quantitative easing and the falling oil price.
They could be “particularly adversely affected” if the strength of the dollar is to be accompanied by even tighter monetary conditions, the BIS warned.
The steep fall in oil prices has caused alarm in some circles. Stock prices in the US fall every time there is a new decline in crude prices, as investors see this as a sign of weaker global demand.
The positive effects of lower oil prices
But not all is gloom. The school of thought that says lower oil prices will encourage consumption, in fact boosting the economy, is gaining ground.
Last week, analysts at HSBC raised their forecast for UK economic growth to 2.6% this year from a previous 2.4%.
Lower oil prices will push inflation to zero or even below but instead of being an unwelcome development, this will provide “a big boost to real pay growth, which in turn supports household consumption,” they argued.
“Moreover, now that the UK is once again a net importer of oil, there is a terms of trade benefit.”
If oil prices remain at this level, the boost this would give to the world economy may be more important than many in the markets are pricing in.
Analysts at Legal and General Investment Management (LGIM) argue that the current fall must be looked at in absolute terms, rather than in percentage terms, to gauge its importance.
If oil prices halve to $50, the world economy’s savings on oil spending represent 2.15% of world GDP – or $1.67 trillion, they noted.
If oil prices were to halve again to $25, the saving would only be another 1.075% of world GDP.
“Today’s shock is far bigger than the 50% fall in oil prices in 1998 to around $10,” according to the LGIM analysts.
The current fall in oil prices would add an “extraordinary boost” to global growth of more than 1.5 percentage points, they said.
Taking into account other variables, such as central banks’ attempts to stimulate economies and the decline in corporate yields, sometimes to negative levels, they forecast the strongest boom since the late 1980s, with global growth at 4.5%.