Tuesday, 30 December 2014

Crude benefits of falling oil prices

The ending of QE in the US and the fall in the price of oil from over $115 a barrel to under $60 a barrel were the defining economic events of 2014, but their consequences will not be felt until next year.  The ending of QE in the autumn brought to an end the huge expansion of the US Federal Reserve’s balance sheet, since 2008 the Fed has pumped some $2.3tn of “new money” into the world economy which has had a wondrous effect on asset prices in all sorts of weird and wonderful places.  London property prices have boomed, stocks in emerging markets reached new heights and bond prices sky rocketed as yields collapsed – also commodity prices boomed and oil was not left out of the party.  Between 2009 and 2011 oil prices rose from $40 to $125 a barrel, driven by ever increasing demand from emerging markets and $1.9tn of US and UK QE.  Following the boom in commodity prices between 2011 and 2013 prices stabilised at a high level before falling off a cliff in 2014.
The Crude Story

Why the price of oil has fallen is less important than its potential impacts – many believe it to be a supply side shock (increased production in the US due to the boom in fracking) or weaker demand from China and Europe as their economies struggle to grow.  Whatever the reason the huge fall in the price of oil at this moment is highly fortuitous as it coincides with the end of QE.  Halving of oil prices has the same impact as reducing interest rates by between 1- 0.75%, this is a massive stimulus (given we are at the "zero bound" of interest rates) for the developed world, as we are often net importers of oil and always huge consumers of the same.   The IMF tell us that- The plunge in the price of oil represents a “shot in the arm” for the global economy which could boost overall world economic growth by between 0.3 and 0.8 per cent.  So who will be the main beneficiaries?

Europe and Japan
For Europe the fall in the price of oil is a very welcome bonus when the politics of QE and German monetary loosening were becoming very difficult.  Some are worried that falling oil prices will just add to the deflationary pressure that has building in the Eurozone, but this is wrong as lower costs of oil must help European competitiveness / productivity, which after all in is the main problem.  A stimulus equivalent to a half point cut in interest rates must be very positive for the whole region.  The question is will this be too little too late, as the Greek election may over shadow everything and if a new bailout is not agreed there may be a catastrophic event that even the falling price of oil cannot mask.  In Japan, where Abenomics looks to be a busted flush, falling oil prices should be a positive in driving productivity, but will not help achieve the (meaningless) inflation targets set by the government.  In Japan the level of public debt,  anemic growth, depopulation and falling productivity make the oil price fall somewhat academic. 

US and UK
The question for the US and the UK, who are at an advance stage of recovery, is whether the stimulus package will be enough to encourage central banks to raise interest rates.  The consensus view is that both the Fed and the BoE will only start to raise rates in the second half of the year and then only very gradually.  With both countries growing at around 3% and with real incomes starting to rise there will be increased pressure on the two Central banks to increase rates more quickly and more steeply.  Lower oil prices will definitely bring forward the time table for high rates in both countries and this will have a substantial impact on the price of the dollar, which could potentially achieve parity with the Euro.  A strong dollar should be good for the US's "relatively closed economy" but could be dangerous for Britain where our current account deficit is a major concern.

Emerging markets
In the emerging markets, where the ending of QE has in many cases been difficult is it difficult to see any good news.  In the oil exporting countries like Russia, Nigeria, Brazil and Venezuela thinks could get very bad and currencies go into free fall and inflation spirals up with ever increasing interest rates.  In the oil importing emerging markets the problem is that US monetary tightening will be mostly negative as it will force interest rates higher locally, when economic conditions may warrant lower rates.  Also the increased cost of dollar borrowings, reckoned to be about $6tn in emerging markets, will weigh heavily on the developing world. 

So the winners are likely to be the UK and the US who are at the most advance stage in the recovery cycle.  They will benefit from the competitive advantage of lower prices and importantly the advantages of positive interest rates; that are a necessary component of a thriving economy where investment and innovation reap the greatest rewards.

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