Bursting bubbles isn't something to be done lightlyby Merryn Somerset Webb / January 22, 2015 / Leave a comment
At the beginning of 2014 most people assumed that the oil price would stay at around $100-110 per barrel. A few predicted a bit of a fall as Chinese growth slowed. One or two perceptive analysts noted that the scaling back of quantitative easing in the United States could be a game changer. But no one, no one at all, suggested that 2015 would open with the oil price at $50. It has.
The move in the oil price has gone from interesting to notable, to kind of scary to utterly spectacular in a matter of months. It is now down over 50 per cent from its levels over the summer. You don’t get moves of that magnitude in the markets often (this is one of the biggest falls in the 139 years of recorded spot prices) and very rarely get them without seeing some pretty serious side effects. A few per cent here and there, sure. But 50 per cent? No. So what’s going on and what does it mean for you?
At first glance, you might think the collapse is all good. After all, if oil is cheaper, modern life is cheaper and that, surely, has to be a good thing. The average UK household spends around 5 per cent of its income on petrol. Factor in oil price falls so far (and assume they filter through to the pump) and economists will tell you we will all be able to raise our spending on other things by around 1 per cent this year. The effect is a bit like that of a fairly material tax cut. That’s good for consumption and good for retailers. It might also mean falling prices of other goods: everyone who transports goods or makes goods out of oil or oil derivatives will be thinking happy thoughts about their expanding profit margins. Cheap oil will also offer a helping hand to the big oil importers of Europe and Asia. But while it is certainly true that cheap oil is on balance a good thing, this time round it isn’t quite so simple. That’s because the fact that the oil price stayed so high for so long (above $90 per barrel for five years) and that it has now fallen so far so fast, are both functions of the same thing: super loose global monetary policy and its eventual unwinding.
Much of the activity in oil has been about government policy: cheap money has driven up both demand and supply.
What kept oil prices high? The answer is partly the Organisation of the Petroleum Exporting Countries (Opec), of course—the cartel still controls some 40 per cent of global oil supplies and has operated as an unchallenged price setter for decades. But it is also China: the huge programmes of economic stimulus in China post the global financial crisis drove demand for energy to the levels that gave us the idea that oil at $90-$100 per barrel was some kind of new normal. The super low interest rates in the United States alongside the whopping doses of quantitative easing facilitated a stunning reaction to that: shale oil. Easy money allowed cash to pour into new energy infrastructure in the US. Over the last few years around one-third of capital expenditure in the US has been energy related and today around 16 per cent of all junk bonds are energy related (that’s four times the level of 10 years ago). The US has now been increasing its oil production by about 1m barrels a day for three years, and shale oil makes up some 2.5 per cent of global production. Look at it like this and you will see that much of the activity in oil has been about government policy: cheap money has driven up both demand and supply.
So here’s the problem: just as the US has become a significant supplier of oil, everyone from Iraq to Libya has pushed up production and Opec has made it clear that it has no intention of cutting supply to hold up prices any more. At the same time Chinese demand has begun to fall off. According to Fathom Consulting, Chinese imports of oil have now been flat since 2012 and all honest indicators now show the economy slowing fast.
This brings us on to the bad news in today’s round of falling oil prices. The over investment in the US during the last few years means there will be bankruptcies and defaults. We just don’t know where they will be yet or for that matter how big or destabilising they will be. We only know that most of the lending for energy projects in the US was done on the basis that the oil price would stay above $80 or so. And that it is now $50. There will also be job losses and fast falls in business investment in the US—note that Halliburton, the biggest provider of fracking services in the US, let 1,000 workers go just before Christmas. The speed of the fall in prices could also have nasty geopolitical effects. Will the predicted 4 per cent fall in Russian Gross Domestic Product for this year as a result of it make President Vladimir Putin feel more or less aggressive? And what will it do to countries such as Venezuela, which needs an oil price of $120 per barrel to have a hope of balancing its budget?
The key point here is that creating bubbles and bursting bubbles isn’t something to be done lightly. The extreme monetary policies of the last seven years will have unexpected, and possibly nasty, consequences all over the place. The falling oil price is about more than cutting the price of commuting in the developed world: it’s a hint of just how tricky the great unwind of the policies we put in place to halt the financial crisis will be.