Are Low Oil prices really good?

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WTI and Crude are the two most common oil indices in the world for the price discovery of oil. They both have a very similar oil concentration, and are usually called light or sweet oil when compared to lower grade oil (such as Sulphur/sour crude oil). In essence, the price of different grades of oils are set according to these underlying prices. For example, WTI is set as the American oil benchmark and Crude is generally the benchmark for parts of Europe, Africa, and Asia.

Those readers who are financially orientated would have recognized that oil has been dropping at an exponential rate during the last couple of years – from its peak of U.S. $147.27 in 2014, it has fallen to a record low of approximately $26.16, breaking a 15 year record that had been in pace since April, 2003.

From a consumer perspective, this is a cause for celebration. Lower oil prices mean consumers generally have more disposable income, increasing savings and greater purchasing power. This is because many prices are correlated with oil, so cheaper oil leads to the cheaper transportation of goods, cheaper energy to power homes, cheaper plastics, gels, jet fuel (which is why the airline industry has soaring profits, especially Qantas) etc.

Oil is a vital cog in the economy and, in literal sense, lubricates the economy.

However, the rest of the economy might have a different view about the plunge in oil prices. This comes back to the general hypothesis that oil is an indicator of global demand and production. Correlation between oil and the global financial markets has been rampantly increasing since the rout in oil prices reaching somewhere around 50% correlation. In layman’s terms, that’s really quite high.

Major world indices such as the S&P/ASX 200 and S&P 500 (US) were down 7.3% and 14.15% respectively at the turn of the year. Not all of this fall is due to oil; some of it comes on the back of a global rout in demand within commodity driven economies such as Australia, stemming from China’s slowly declining pace of economic growth, and also partly because of uncertainty in financial markets brought on by the lack of stable central bank policy around the world.

However, this high correlation between oil and global security is causing pain for fund managers around the world. For consumers, this means that money investment in pension funds, superannuation, retail funds, and general investments is likely to fall in value as market risk reaches its highest value since the China devaluation, indicated by the VIX index, which generally measures level of volatility.

As if that was not enough, oil prices being low are not the factor that’s most alarming to the market. Rather, it is the repercussion of oils unintentional spill over into inflation, or deflation in some cases. If Japan’s lost decade from the 90’s (persistent deflationary pressure and stagnant growth over a decade, which some believe is still going) is anything to go by, it is that deflation is a greater cause of concern than high inflation.

Deflation, in economic terms, is quite scary because it can spiral and become a self-fulfilling prophecy of economic turmoil. Deflation to rational consumers like you and I incentivises us to hold off spending and wait for lower prices in the next period, and when we do so, this lowers economic activity and investments. In most cases this also leads to a loss of jobs and income, which means you have less money to spend and are therefore, now again incentivised to wait longer for prices to fall so you can afford the same amount of units with the reduced income you have and the cycle continues.

Due to frequently external factors such as central banks intervening to stop deflationary spirals, this doesn’t happen often. Deflation, along with other factors, and its correlation with oil which correlates with global markets, is the reason why oil prices falling too quick and too fast are not a net benefit for consumers in the long-run. Oil prices, when steadily falling to its mean-reverting average, is a positive for consumers with little dead weight loss (economic inefficiency), but dislocation of supply and demand leads to falling prices and large values of dead weight loss upon society.

Why should we be alarmed?

As Mark Papa, former EOG Resources Inc. CEO said, “Over the long-term, U.S. shale drillers could become the dominant producers in global markets, ahead of the world’s largest supplier, Saudi Arabia. Producing up to 13-14 million barrels a day by 2022.”

This correlation of oil and market volatility might dissipate over time, but deflation could become a real obstacle and constrict global growth.

Co-published by the Trading and Investment Collective