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US shale
US Dollar
World Oil prices

The world according to oil

Glenn Fairbairn
Director/Private Client Adviser
12 Jan 2015

Surging US shale supply, weakening Asian and European demand, and a stronger US dollar have pushed the price of oil to a five and half-year low. In 2014 oil prices dropped a whopping 48 per cent after three years of the highest average prices in history. 

Not only this, but a mini price war has erupted between OPEC and the US. For the first time since its formation in 1960, two of the top three oil-producing countries (the United States and Russia) are outside OPEC. While OPEC controls low-cost oil, it has lost supply control at higher prices and cannot push prices up like it could in the 1970s – or at least, not without stimulating a lot more supply from elsewhere.

According to the US Energy Information Agency, the United States now produces 11.1 million barrels of oil per day – about the same as Saudi Arabia (11.7 million barrels) and Russia (10.4 million barrels).

OPEC members know that cutting their own production would no longer have a big effect on the global supply of oil. Even if they could drive up the oil price, this would only invite more competition that would hurt their revenue.

The expectation is that OPEC is likely to allow prices to keep falling in the hope that many of the newest drilling projects in the US will prove unprofitable and shut down. This is a risky stand-off for OPEC as many of its member countries require high oil prices to balance their budgets.

Iran, for one, is facing a real pinch. It’s also a sign that OPEC’s influence over global oil markets may be waning.

What does this mean for the global economy?

Following OPEC’s meeting in November, where they confirmed that they do not plan on cutting their current output, share markets around the world, in particular energy stocks, were sent into a flurry as investors became anxious about the impending uncertainty and the impact that cheaper oil may have on the global economic recovery.

The major concern is the impact of deflation i.e. the falling cost of goods and services. Deflation is not necessarily bad, but often periods of deflation/low inflation can lead to economic stagnation and periods of high unemployment. This is because deflation can discourage spending as things will be cheaper in the future. Deflation can also increase real debt burdens, for which many developed nations carry.

However, there is a potential upside. According to the World Bank, the slump in oil prices is set to boost the global economy, with crude-importing countries expected to substantially benefit. Their research shows that a 10 per cent drop in oil prices would increase gross domestic product in oil-importing countries by 0.1 percentage points to 0.5 percentage points.

The World Bank’s most recent forecast for global growth in 2015 came out in October 2014, predicting a rise of 3.2 per cent. In China, a 10 per cent drop in oil is expected to lift the growth by 0.1 to 0.2 percentage points, so the current slump will likely boost the world’s second-largest economy strongly.

In other developing economies, lower oil prices can reduce governments’ need to provide fuel subsidies and thus bolster their coffers.

Among advanced economies, Hong Kong is the biggest winner, while Saudi Arabia, Russia and the United Arab Emirates fare the worst, according to Oxford Economics. They estimate that for growth, a long-lasting price of $US60 per barrel would add a 0.5 percentage point to global gross domestic product.

An Oxford Economics study found that the US, still a net oil importer, would accelerate economic growth to 3.8 per cent in the next two years with oil at $US40 a barrel, compared with 3 per cent at $US84 per barrel.

What does this mean for investors?

Although the continued uncertainty regarding the future price of oils is likely to add sustained volatility to global markets, it is only a matter of time before investors get used to this new phenomena. In any case, common belief is that prices should begin to stabilise within the next 18 to 24 months.

Presently it seems supply will outstrip demand and this is likely to lead to reduced returns for new investment and makes many projects non-commercial. But eventually supply will ease and prices should stabilise.

In the meantime ignore the noise and stick to your long term strategy.

Hewison Private Wealth is a Melbourne based independent financial planning firm. Our financial advisers are highly qualified wealth managers and specialise in self managed super funds (SMSF), financial planning, retirement planning advice and investment portfolio management. If you would like to speak to a financial adviser on how you can secure your financial future please contact us 03 8548 4800, email info@hewison.com.au or visit www.hewison.com.auPlease note: The advice provided above is general information only and individuals should seek specialised advice from a qualified financial advisor. The views in this blog are those of the individual and may not represent the general opinion of the firm. Please contact Hewison Private Wealth for more information.