Story Of The Week

Falling oil prices- a boon or bane?

Oil is amongst the largest traded commodities in the world and undoubtedly has a ubiquitous influence. Therefore, it is no surprise that it has become the hot word of late as prices of the “black gold” plummeted to as low as $27 per barrel of crude from prices which were in the range of $100 during 2014. Thus, it isn’t an uncommon sight to find a headline, talking something or the other about oil, starring right at us from the front-page of a daily every day. Common wisdom would say that it is good that oil prices have dropped significantly to such lows. However, this fall is like a double-edged sword and this article is our endeavour to capture all those aspects which are related to this phenomenon.

Why it happened?

Before we delve into the pros and cons of this occurrence, it is equally important to understand the reasons behind this fall in oil prices. To put things simply, it is an economic outcome of supply and demand. It was the discovery of shale oil in the U.S. sometime around the end of 2013 which first upended global oil trade. The U.S. started producing a substantial amount of oil and eventually surpassed Saudi Arabia to become the largest producer of oil in the world. Thus, U.S. cut its oil import bill significantly. At the same time, China, which is the second largest consumer of oil in the world (after the U.S.), started showing signs of slowing growth in 2014 which directly impacted demand for oil. Oil prices thus started to fall from mid-2014 onwards. Further, with the lifting of sanctions against Iran recently, the already existent oversupply is poised to increase significantly. Thus, the total demand in the oil markets has fallen, accompanied by an increasing supply of the commodity at the same time. Experts are of the view that the weak demand has contributed about 30% to 40% while the excess supply has contributed about 60% to 70% of the fall.

The falling prices have been likened to a double-edged sword and therefore have both favourable as well as unfavourable consequences.

Hurting oil exporters, jobs and demand

The fall in the prices of oil have hurt the revenues of oil exporting countries like Saudi Arabia, Russia, some Latin American countries and many others drastically. For countries which do not have any other significant sources of revenues, like Nigeria, the consequences are even graver. Nigeria which makes up 95% of its foreign exchange via export of crude oil has been left with a huge gap in its budget which it will eventually have to fund via various methods of financing which would impact its current account. Further, many oil producing companies have been struggling to meet costs. With Iran poised to enter the oil markets to add to the oversupply of 2 million barrels per day, prices are expected to drop further and hurt margins. As various companies struggle to meet costs, the only way for these corporations to meet them would be via job cuts. This would further weaken the demand of other goods as people would have lesser disposable income, thus giving birth to a vicious cycle. The shortage of funds with the oil companies would also result in significant reduction of oil exploration activity.

Foreboding a global predicament?

The most significant fear is that falling oil prices have foretold a global slowdown due to lower demand, and thus analysts have predicted a fall in global output for the next couple of quarters. To add to this, due to the projection of a slowing Chinese economy, fear of a recessionary phase looms large. The stock markets have been indicators of global economic growth and naturally, the drop in oil prices have had a big reflection in the stock markets too. Stock prices of oil producing companies (and any company adversely affected by the fall) have dropped sharply. Moody’s Investors Service recently said it may downgrade the ratings of 120 oil and gas companies as prices of oil remain at multiyear lows. A further correction in the stock prices of these companies is expected which would drive down the stock indices further. This would impact investor sentiment, especially for emerging markets like India, where some analysts are even predicting that the Sensex could go well below 23000 levels.

The bright side

However, like we said, there is also a bright side that has accompanied this fall. The drop in prices of oil is good for net importing countries like India which should fully capitalize on the gains to reduce its Current Account Deficit. The fall in oil prices will also reduce consumer spending in this category as the government passes on the benefits to them by reducing prices of fuels. This could help increase demand of other goods. The fall in oil prices is also beneficial for sectors heavily reliant on oil for operations, such as the aviation sector where aviation fuel prices have been reduced sharply (like in India). The benefits realized by the companies will further trickle down to the consumers soon. Further, for countries like India where a large part of government expenditure goes towards subsidy in fuels, governments could mull over policy reforms to eliminate the subsidies. Many countries in Europe are not in great shape and a fall in oil prices would be welcomed by them too.

Conclusion

How long would this last? Experts predict that this strain will continue across 2016 at least. However, no one is absolutely sure of this, as is the case with almost all predictions, and it could go either ways. Oil prices are very low today and no producer of oil is backing up and reducing the production of oil (which would drive prices up) to meet their costs, in the fear of losing market share (like Saudi Arabia lost in the oil crisis of 1980s). Saudi Arabia, the largest producer of oil amongst the OPEC members has stated categorically that it will not lower production levels, and still continues with the strategy of maintaining market share. Saudi Arabia has a lot of foreign exchange reserves to sustain it for many years, which producers in other oil producing countries do not have. It is thus banking on the strategy of using up the reserves whenever required in the hope of driving out competition, leading to the rise in oil prices again. Companies in the U.S. have also not reduced production as they have borrowed substantial funds in the tune of couple hundred billions of dollars and fear of being shipped out of business and getting downgraded. Investors on the other hand are shying away from investing in various economies from the fear of slowing demand and a looming recession. This would further slow growth. As we can all see, this is quite a complex situation and would take some time before things shape up to desired forms and before the “black gold” reaches a value which would be comfortable for all.

References

http://www.business-standard.com/article/opinion/oil-price-trough-116012001194_1.html

http://www.telegraph.co.uk/finance/oilprices/12093667/Crude-reckoning-what-will-oil-price-slump-mean-for-the-global-economy.html

http://www.marketoracle.co.uk/Article53751.html

http://www.economist.com/news/leaders/21688854-low-energy-prices-ought-be-shot-arm-economy-think-again-whos-afraid-cheap

http://forbesindia.com/article/checkin/oils-fall-is-a-doubleedged-sword/41975/1

http://forbesindia.com/article/special/more-pain-in-the-offing-for-equity-markets/42005/1

http://forbesindia.com/article/column/the-new-oil-shock-the-great-sweating/40465/1?utm=slidebox

http://www.forbes.com/pictures/gegi45fkf/1-united-states/

http://www.reuters.com/article/us-oil-pira-idUSL1N0I51IX20131015

http://www.bbc.com/news/business-29643612

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