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On balance, falling oil prices are better for world economy

By Mark Arndell, investment centre manager at Danske Bank

Published 19/01/2016

The cut in oil prices does mean we pay less at the petrol pumps
The cut in oil prices does mean we pay less at the petrol pumps

Oil fell to below $30 a barrel last week, a 12 year low. In a world dependent on energy, lower prices should be a good thing you might think as we look forward to cheaper heating oil and less spend at the petrol pump.

The markets saw things differently however. They focused on slowing growth in China and lower demand across global markets. As a result they fell. Several major markets have now fallen by 20% from recent peaks, the technical definition of a 'bear' market.

The decline in oil price was caused in part by Saudi Arabia maintaining excessively high levels of production last year, the continued buoyancy of US shale producers and concerns of even greater supply as Iran, now back from the political wilderness, returns to the markets. Saudi Arabia's aim in over supplying the market was to damage higher cost producers, such as the shale oil suppliers in the US, by driving down prices. This has backfired somewhat as it is now struggling to meet fiscal commitments at home. Healthcare, education and major infrastructure projects may be put on hold due to falling oil revenues. This is hurting Saudi to the extent that it is considering privatising part of the state owned oil company, Aramco, to raise the necessary additional funds. Aramco is by far the biggest company in the world generating $1bn a day in revenue so even the sale of a small fraction could raise significant funds for the Saudi government.

Crude oil has been used to make fuels and industrial chemicals since the 1850s and the world currently has 1.2 trillion barrels of proven oil reserves, good for another 40 years at least. The price of oil is one of the most important drivers of the global economy, but not all types of oil are priced the same. There are hundreds of grades, from heavy tar to light 'sweet' crude. The current international standard grade is Brent Crude, from the North Sea, and it's priced by individual tanker load.

The other commonly traded grade is the American, West Texas Intermediary or WTI, which flows through a single pipeline in Cushing, Oklahoma and can be priced more evenly. Both Brent and WTI have traded at different levels over the years but now trade at more or less the same price. They ended last week at $29.14 and $29.39 respectively.

Many analysts expect the oil price to remain around current levels for some time with over supply likely to remain in the short term. These are not abnormal levels; oil traded around $15 to $25 for most of the Eighties and Nineties and only rose to its peak at $140 during the financial crisis in 2008.

That said, low prices are hurting the oil majors like BP and Shell who are currently shelving major projects and reducing costs. This will gradually reduce global oil supply and create the conditions for price rises. The oil price could also be driven up quickly by global shocks such as we saw with the wars in Iraq or Hurricane Katrina in 2005.

On balance, a world with lower oil prices is a net benefit. Leading markets, such as the US and Europe, should benefit from a combination of greater personal consumption and from lower energy costs in the long run, reversing the downward trends in global stock markets.

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