Crude oil is set to close out a appalling year with a fresh five-year price low in the final days of 2014, falling more than 50 percent from their June highs. The decline keeps on to bedevil the markets. Sensing a rally was in order, speculators had dumped money into energy stocks throughout the month of December, hoping to buy up positions at basement prices. But Bloomberg reports that long positions in West Texas Intermediate declined by the most since August for the week ending on December 23, an indication that the markets have lost confidence in a swift rebound for oil prices.
Reason which makes the oil price collapsed:
Put simply the oil price has collapsed because the global supply of oil has surged in relation to demand. Last decade saw the price of oil go from $US10/barrel in 1998 to $US145 in 2008.
This sharp rise in the oil price both in nominal and real terms encouraged greater fuel efficiencies (use of ethanol, electric cars, etc) and more significantly encouraged the development of new sources of oil. A noteworthy example of this has been the surge in US shale oil production this decade which has taken US oil production back to 1980s levels.
This is similar to what occurred in response to sharp rises in oil prices in the 1970s, which then resulted in much weaker prices through the 1980s and most of the 1990s.
Implication for share markets:
Share markets have at the start reacted negatively to the fall in oil prices because the negative impact on energy producers is what is most visible and this is being magnified by the steepness of the fall. To be sure this brunt could linger for a while yet and some sort of blow up – like further problems in Russia or a default by a more marginal energy company – cannot be ruled out.
However, the risk of a major threat to the global economy or share markets from energy producers is low:
U.S. energy production was a bigger share of the U.S. economy in the 1980s and yet the mid-1980s fall down in oil prices helped boost the economy and share markets back then;
While the Russian economy is facing a crisis (made worse by its own actions in Ukraine), a 1998 style Russian public debt default looks unlikely. Russian public debt is low at around 9% of GDP compared to more than 50% of GDP in 1998, public debt in foreign currency is trivial and foreign exchange reserves are much higher now. Private debt is more of an issue now but much of it is owed by just two companies (Gazprom and Rosneft) who have foreign exchange earnings and the Russian central bank has indicated it will help out companies meet foreign exchange obligations.
In simple words, it’s likely that over time the positive impact on global growth and hence profits from lower oil prices will overlook and this will help drive share markets higher by year end. After oil prices plunges into 1986, 1998 and 2008 US shares gained an average 23% over the succeeding 12 months.
As a result any noteworthy dip in share markets in response to lower oil prices should be seen as a buying opportunity.
