The impact of the ever disappearing crude oil price

One of the features of the economic landscape since the summer of 2014 has been the falling oil price. If we look back it feels that the price of just below US $116 per barrel for Brent Crude Oil is from another economic world and of course that is true now. But back in late June 2014 it flirted with such levels after even higher prices and of course forecasts. Goldman Sachs were (in)famous for calling for US $200 oil in 2008 and in 2011 Nomura stepped up to the plate.

If Libya and Algeria were to halt oil production together, prices could peak above US$220/bbl…… we estimate oil could fetch well above US$220/bbl, should Libya and Algeria stop production.

How much is well above please? Anyway I introduced some past forecasting perspective because this week has already seen some efforts at forward guidance on this front. From Bloomberg.

A rapid appreciation of the U.S. dollar may send Brent oil to as low as $20 a barrel, according to Morgan Stanley….“Given the continued U.S. dollar appreciation, $20-$25 oil price scenarios are possible simply due to currency,”

Oh and a familiar firm had already predicted such a number.

Goldman Sachs Group Inc. has said there’s a possibility storage tanks will reach their limit, pushing crude down to levels necessary to force an immediate halt to some production.

An easy one for the spreadsheets as all they had to do was remove a zero from the past spreadsheets as I guess we are all reminded about the “Muppet” scandal. In such a situation what is an investment bank to do? Well this is the solution from Standard Chartered via Reuters.

“We think prices could fall as low as $10/bbl before most of the money managers in the market conceded that matters had gone too far,” it added.

Should it happen then one contributor may finally be happy with the oil price 🙂

Where are we now?

The first wave of the oil price fall took us down into the mid 40s in terms of the US Dollar and it did so around this time last year. following that there was a bounce to nearly US $70 but then the move acquired a second wind. Since the middle of May 2015 the oil market has again acquired a taste for the repetitive rhythms of Status Quo.

Get down deeper and down
Down down deeper and down
Down down deeper and down
Get down deeper and down

This morning Brent Crude Oil dipped below US $31 per barrel finding itself going back in time to 2004 as it did so. There has been around a 20% fall this January alone and market volumes have been very high. Combining this with the rumours of an emergency OPEC meeting which have just arisen makes me wonder if someone is what is called “long and wrong” in size? I will return to this issue later. But for now we return to an oil price which is much lower.

The impact on inflation

If we start with producer prices then most input numbers have been blitzed by this. for example we have been reminded of this today by the UK’s poor manufacturing numbers.

Input prices paid by UK manufacturers fell by 13.1% in the year to November 2015……..Over the past year the manufacturing industry has experienced deflation, in terms of the prices manufacturers pay for materials and fuels used in the production process (input prices) and the prices they charge for the goods they produce (output prices).

As UK manufacturing has fallen over the year for once the deflation moniker has some justification. I covered the problems there back on December second of last year.

There is also the impact on consumer inflation which we can look at from today’s official data on fuel prices at the pump. The price of petrol at 101.9 pence is some 7 pence lower than a year ago and the price of diesel at 103.4 pence is some 12.8 pence lower than a year ago. So not only are we seeing a price fall there is a welcome price bias for diesel drivers like me. The direct impact on consumer inflation is show below.

A 1 pence change on average in the cost of a litre of motor fuel contributes approximately 0.03 percentage points to the 1-month change in the CPI.

As you can see in just very round numbers we are looking at a 0.3% push lower from the direct effect and of course there are many other effects. There is the direct effect on domestic energy costs -well hopefully anyway- and lots of indirect influences on fares and transport costs. But the fundamental point is that an influence which might have faded in the latter part of 2015 is pushing into the early part of 2016.

This will be an influence on central bank and indeed Bank of England policy as it continues to pull us away from the 2% per annum CPI inflation target.

Economic activity

There are various routes as to how a lower oil price can benefit an economy. On the 29th of January last year I explained how I expected lower inflation to boost real wages and lead to a boost in consumption in the UK ( and Ireland and Spain). That proved to be true and has been in evidence in quite a lot of places although its impact on the United States has been relatively weak.

If we look at the overall impact then Price Waterhouse estimated this last March for the UK.

in Scenario 1, where the oil price remains persistently low at US$50 per barrel between 2015 and 2020, the initial impact will raise the level of real UK GDP by around 1.2% in the first year.

We have had that of sorts and are now facing the possibility of a sustained oli price that is even lower although of course matters are volatile. But the theme here is of an economic boost which also will get a second wave if oil prices remain at current levels or fall further.

For the UK there has also been something of a (space ) oddity from the oil price fall. Take a look at this from today’s poor production numbers.

There were increases in 3 of its 4 main sectors, with the largest contribution coming from mining & quarrying, which increased by 10.5% (on last November).

Curious is it not? I will have to enquire again as I am not sure that the impact of the maintenance cycle can fully explain this ongoing rise. You see if we look back UK oil and gas production has been in secular decline.

mining & quarrying and electricity, gas, steam & air conditioning, which continued to decline following the downturn, were 29.4% and 9.1% below their respective values in Quarter 1 (Jan to Mar) 2008.

A transfer from producers to consumers

Not everybody has gained from the oil price fall as producers have been hit hard. This has appeared in the news in various guises from the falls of the Russian Ruble to the budget problems and currency issues of Saudi Arabia to problems for parts of Africa. There must be issues for Canada as well as its tar sands oil has an even lower price than the ones quoted above.

So there are implications here from a transfer of economic gains or to be more specific lower transfers from consumers to producers. In our highly stressed world we have to question if our system can take it.

Derivatives, derivatives

The issue here is of what has become called a Black Swan event which is certainly easier to type than the serially uncorrelated error term! If we return to the concept of our stressed world then an obvious issue is the economic model of the US shale producers which looks to have been essentially a cash flow projection except much of the cash has dried up. There will be trouble ahead with anything like the current oil price and the only question is how much?

The indirect issue comes from my old line of work in derivatives. With oil at US$100+ and projections for US $200+ what could go wrong with writing some US $70 or US $60 put options? Free money isn’t it? Oh hang on…….

Big moves in our financially stressed world lead to fears that some have been caught out and the size of the move would be the prospective problem.

Comment

In ordinary times then for most nations the oil price fall would be nearly unambiguously good news. The fly in the ointment would be a reduction in demand from the oil producing nations and areas. So we continue with the associated good news of lower inflation and higher economic output as the impact of an improved real wage position is felt.

The danger is that in the race for “yield and returns” someone has been a combination of silly and desperate and done so in a large volume. Fingers crossed.

 

 

 

 

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23 thoughts on “The impact of the ever disappearing crude oil price

  1. Hi Sean
    The fly in the ointment would be a reduction in demand from the oil producing nations and areas ?
    Is that what you meant ?
    Mike T.

    • Hi Mike

      Yes. Just to make it clearer I meant that the oil consuming nations would see demand for their exports from the oil producing nations fall. How big an issue that is depends on the trading pattern and size.

  2. Hello Shaun

    Yes it seems we may have to bail out the dammed BANKS again , doesnt it?

    I believe many of the US shale producers have been economical with the truth about what are reserves – chickens are coming home to roost !

    the vultures are circling and will pick up oil co with pennies on the dollar values, then they can sell that oil cheaper , and the loosers ? well the sunk costs are well and truly wasted monies

    still the decider will be not the day to day price of oil but its yearly average.

    Still sure there’s no recession on the horizon , Shaun?

    Forbin

    • The potential risks for the shadow banking system are huge is some of the shale producers or explorers start defaulting are huge.

      People were queuing up to dig holes in their back yard at $100+….now they’ve got an empty hole and billions is junk debt.

  3. in other news

    UK oil firm BP has announced it is cutting 4,000 jobs globally, 600 of which will be lost from its North Sea operations.

    BP said all the job losses would occur in its oil exploration and drilling business.

    only expansive oil left there , in small fields , seems even technology cant save the UK oil business

    Good the balance of payments though , well it should be , all this cheaper oil and commodities,

    Doesnt seem to be helping us much though

    Forbin

  4. I wonder if the oil “market” has been manipulated in the way most other markets seem to have been in recent times. According to zerohedge there has been a spike in the oil price today as a result of the bomb in Istanbul. This got me thinking……. I wonder if the oil price has been pushed lower up until today’s spike because it’s reportedly the main way in which ISIL raises funds? Just a thought although the glut in oil production must be the main driver of the price.

    • Hi Jan

      You are not the only person who has thought of the “ISIL” link as I have been wondering if lowering the oil price is a way of reducing their revenues from the oil they pump. I would be more sure if I was absolutely sure which side Saudi Arabia is on!

      As to the manipulation issue then yes I do believe that the oil market was gamed by the various bank trading desks and that contributed to its surge. Their withdrawal from the market as commodity desks closed has took away upwards pressure and thereby helped the fall but I do not know if others have actively pushed it down.

      Of course central banks have had a role in pushing the oil price down as it is all their QE which has allowed the high borrowing model of shale oil and gas to exist. Therefore low inflation is to this extent a consequence of their past actions. Oh dear!

  5. Shaun, these recent and unexpected further falls only continue to challenge any past and contrived scope for sustainable business models. I think every investor must have a walkaway number. Lower barrel prices wil only bring forward that calculation. Black swan is is not but you may suppose 2nd order effects might be.

    We know that US shale is only economic down to 50 at best, so once commercial operators throw in the towel it becomes a national security issue. I think once US gov is actively and publically financially supporting shale producers we will enter the next chapter of this internationally critical commodity. Paul C.

    • Hi Paul C

      I agree that we are entering a new phase. What will governments do if shale oil and gas companies start to fold -which seems likely at this oil price- and perhaps they take a bank or two with them? We then face the prospect of yet more bailouts.

      As to your idea of the US government ending up as the shale oil producer well it has the advantage of being able to borrow much more cheaply. ironically since the US Fed raised interest-rates it can now borrow at a lower rate with the 10 year rate being 2.1%. Would shale be viable down here at such interest-rates?

  6. Great column, as usual, Shaun.
    You mentioned that the oil price fall must have issues for Canada too. Indeed it does, but they are different for the Bank of Canada than they are for the Bank of England. Since we are an oil exporting country, the drop in the oil price has had a net inflationary impact, especially for the CPIX measure of core inflation that the BoC uses as its operational guide. It excludes fuel oil and motor gasoline, but is sensitive to the drop in the value of the loonie pushing up the price of imports. The CPIX inflation rate has been above the 2.0% target since August 2014. Unfortunately, the BoC’s answer to the problem seems to be to change the measure of underlying inflation, as I noted in the attached letter to the editor in the Toronto Globe and Mail:
    http://www.theglobeandmail.com/globe-debate/letters/jan-9-buckle-up-rough-economic-ride-ahead-plus-other-letters-to-the-editor/article28086517/
    My son Miki said he didn’t know who David Bowie was when I told him he had died. I told him that he wrote the song “Is There Life on Mars” that I annoy him by singing all the time. He said that he didn’t actually mind the song, just my terrible singing voice. It’s a terrible loss, but Bowie’s music will live forever.

    • I can see oil exporters having a BoP problem with a reduced oil price, but I don’t understand it causing inflation; would you explain for me please?

    • Hi Andrew and thank you.

      It is a good letter which I hope will be read at the upper echelons of the BoC. I was just wondering about the mortgage rate fall in Q3. Do Canadian mortgage rates track the official BoC rate?

      • Thank you for the kind words, Shaun. There was a 1.2% decrease in the mortgage interest CPI from 2014Q4 to 2015Q4, and this came from interest rates, not from housing prices. Variable-rate mortgages in Canada will pretty closely track changes in the overnight rate. In 2009, they constituted 27.9% of household mortgages; this share goes up and down from year to year but it is probably close to that now. Most other mortgages are fixed-term, six-month, one-year, three-year, five-year, seven-year, 10-year. The stock of such mortgages will not, of course, have their mortgage rates move in lockstep with the overnight rate, but new initiations usually will see their rates go down if the overnight rate goes down. There are also some combination mortgages, e.g. a variable rate mortgage where the mortgagee has the option of switching to a fixed rate. An important point is that, unlike the mortgage interest RPI in the UK, the Canadian mortgage interest CPI does not currently monitor variable-rate mortgages. It is only based on fixed-rate mortgages. A 2010 study by Olfa Khazri showed that if variable-rate mortgages were included in the mortgage interest component it would make the CPI All-items considerably more volatile than it is. Just the same, it would be a desirable reform from the point of view of an index used for upratings, as it reflects the reality faced by Canadian consumers. If the BoC did replace CPIX as its operational guide with the common component of CPI measure in 2016 and StatCan decided to monitor variable-rate mortgages in the CPI in 2017 or 2019, then its new operational guide would be much more volatile than its old one, and far too volatile to be useful. The BoC should really be working at reforming the CPIX rather than replacing it.

  7. If we are all spending every penny we can on mortgages, rent and the like, oil prices can go negative and it won’t stimulate demand.

  8. Oil has been speculative traded like any other commodity, $116 June 2014, $31 today. These fluctuations have nothing to do with supply, demand and level of reserves, but about making a quick buck. Who are the people trading oil for profit, it can’t be the hedge funds, the banks etc – can it?

    • Hi ExpatInBG

      So that is a fair bit lower than the UK. In fact it allows me to add something which I should have put in the article which is that the tax base of petrol and diesel in the UK is circa 75 pence per litre ( Duty is 57.95 pence and VAT is on the lot). So we cannot get down there! Actually with the price down here I have been wondering if the fuel price escalator might see a return as the UK government could do with some more revenue.

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