Driving down the oil

Falling oil prices have compounded fears, in the developed world at least, that disinflationary pressure is set to last, further harming economic growth. However, the canaries are still fluttering, indicating that the lower oil price is more a symptom of oversupply than lower demand.

There are two main benchmarks for international oil prices: the West Texas Intermediate, which is a US measure, and Brent, which is oil from the North Sea. The prices of these two benchmarks used to track each other pretty closely. But differences in the quality of the oil and anomalies in the capacity to refine mean that these days the price of a Brent barrel of oil is generally seen as a more accurate reflection of the true price. However, what is true of both benchmarks is that they have declined dramatically in recent months. WTI is down 16 per cent since the start of the year, while Brent has fallen by 23 per cent, and at US$84 a barrel is at its cheapest in almost four years.

The recent price drop has come as a surprise. Granted, there was a weakness in the economic data in some regions of the world, but nothing to warrant such a sharp decline. As oil prices are measured in US dollars, the appreciation in the greenback also means that the price of oil declines. However, just like many other asset classes, the clearing price for a barrel of oil can simplistically be determined by supply and demand, and a falling price suggests either an excess supply or a reduction in demand. In this case, it is the first factor which has driven the decline in price.

Saudi Arabia is considered to be the swing oil producer, in that it will cut or expand production based on total global output to maintain a certain oil price. In the height of the Libyan crisis, for example, Saudi Arabia increased production to offset the fall from Libya. The trouble is they never turned off the flow again, hence today’s oversupply as Libyan oil production has started again. Saudi Arabia may have been front-running the increase in geopolitical risk in the Middle East. After all, why cut production back when there is a chance that an oil shock may come from fighting in Iraq?

However, an alternative view is that Saudi Arabia is deliberately holding the price down to dampen the supply from non-OPEC producing countries. Over the last few years, this supply has grown phenomenally, especially from US shale oil. The US shale oil output is more price-sensitive, particularly for the smaller producers, although they could probably withstand the current price level and potentially even lower prices. The break-even point for US producers may be lower than Saudi Arabia thinks, as technological advances in the fracking process have made it cheaper to extract oil.

Many of the arguments about the falling price of oil miss one salient point: the benefit it provides to businesses, consumers, and oil-importing nations. Some estimates suggest that a US$10 drop in the price of a barrel of oil translates into a 0.5 per cent increase in economic growth in oil-importing countries. Consumption in those countries should pick up from the extra money in the pocket of the person on the street. In the US, for example, the lower global price of oil is quickly translated to lower prices at the pump as indirect taxes are low, meaning spending should pick up elsewhere in the economy. Unfortunately, the same is not quite so true for the UK, where petrol costs take a little longer to reflect global prices.

A cut to production levels may be forthcoming at the upcoming meeting of the Opec countries in November. This would provide support to the oil price, although it is unlikely to rise back over US$100 – many economists forecast prices around US$90 a barrel for the coming years. So consumers should still benefit, and oil should still drive global economic growth.

Kerry Craig is global market strategist of JP Morgan Asset Management