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Wednesday, 13 December 2017

The oil price fall: Back-loaded benefits on the way

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  • James Saft - June 2014

Saft: It looks like the right kind of deflation, if only for a time.

(Reuters) - Economies and investors, having suffered the pain of the tumble in energy prices, may soon start to see more of the benefits.

While markets were quick to price in the negative effects of falling oil prices on producing countries and companies alike, the benefits, both to consumers and economies as a whole, take longer to arrive.

Brent crude oil prices have tumbled nearly 60% since June to below US$50 per barrel, claiming several high-profile victims in the process.

Russia, highly dependent on oil earnings and suffering from the effects of sanctions over its conduct in Ukraine, has seen its currency and stock market tumble. High-yield bonds, a sector with a heavy concentration of the more speculative oil companies, have fallen markedly.

Sagging energy prices have also likely contributed to lower global interest rates, put downward pressure on inflation in major economies and may be influencing central banks to keep money conditions easier than they might otherwise.

“The effects of the oil price decline are being priced in now, for example in the Russian currency, the share price of UK oil companies and the energy sector of the U.S. high-yield debt market,” Keith Skeoch, CEO of Edinburgh-based Standard Life Investments, wrote in a note to clients.

“So on balance we conclude that supply side rather than demand side factors are more important, and into spring 2015 we should start to see the more beneficial effects of cheaper energy feed through, in consumer spending and non-oil corporate investment.”

The worry has always been that the tumble in oil presaged a more general downturn in the global economy, which has happened in the past.

Though demand is slowing rapidly, notably in China and weaker parts of the euro zone, other factors argue against interpreting the energy tumble as a warning sign. For one thing, broader commodity prices, while retreating, have fallen only about half as much as oil, a point not consistent with a generalized downturn in demand.

At the same time, new supplies of oil have been coming online, made possible by new technology that has been seeping into the market for years, and the Saudi decision not to tighten supply.

Overall, the International Monetary Fund estimates that the fall in energy prices is 60 percent attributable to supply issues.

Payment upfront, benefits to lag

Now we get to the good part.

Both the IMF and World Bank have recently revised down their global growth forecasts for 2015. Both agree, however, that cheaper gas at the pump and energy for factories will give a boost to growth. The IMF sees an extra 0.7 percentage point of growth this year and 0.8 percentage point in 2016, while the World Bank sees about a half a percentage point extra over the “medium term.”

Analysts at Barclays Bank looked at the five similar oil prices declines of the past 30 years and found that while they tended to happen as growth was slowing, a rebound comes 6 to 9 months after the decline in prices.

“We expect to see positive effects in PMI indicators and retail sales in coming months, which in itself should strengthen markets’ belief in the beneficial global growth effects of lower oil prices,” Christian Keller and Apolline Menut of Barclays wrote in a note to clients.

This may be particularly true in the United States, where due to lower energy taxes, more of the impact of cheaper energy will drop directly into consumers’ pockets.

Think of a fall in energy prices as being a bit like quantitative easing for Main Street.

QE drives up the price of financial assets owned mostly by the well-heeled, who are not likely to increase consumption. But cheaper gasoline and lower utility bills spread their benefit more widely among middle class workers who have seen their incomes fail to rise in step with the better-off and are far more likely to spend the proceeds.

To be clear, the losers, from Russia to Venezuela to the Dakotas, will continue to suffer, and capital investment and spending will be hit selectively.

Eventually, marginal energy production will come off-line and planned investment shelved, meaning that some time in 2016 we likely will see energy prices rise again.

Until then, we will see tangible benefits: better spending and investment in major economies and lower interest rates than we would otherwise have enjoyed.

It looks like a bit of the right kind of deflation, if only for a time.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)

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