Lower Oil Prices: 5 Reasons & Impact

The Current Situation

Brent crude oil prices (a major benchmark price for purchases of oil worldwide) have fallen from a peak of $116 per barrel in June 2014 to $86 per barrel in September 2014. This fall in price (around 25%!) is due to a dip in oil demand which dipped to 93.4 million barrels per day in June 2014 to 92.1 million barrels per day in September 2014. However the supply of oil has increased from 91.3 million barrels per day to 95 million barrels per day (Source Bloomberg).

One of the largest components of India's import bill is oil; India imports close to 80% of its crude oil requirements. A fall in crude oil prices would immensely benefit India, helping reduce its trade deficit (negative balance of trade in which a country's imports exceed its exports). Net oil imports for the fiscal year 2013 stood at $105 billion vis-à-vis $144 billion in the previous year. In my view oil prices could remain benign in the near future for the following five reasons.

And the five reasons are:

1. Global growth is expected to be low - The International Monetary Fund (IMF) has revised its GDP growth outlook for the current year to 3.4% from 3.8% and for the next financial year its forecast is 3.8%. This is the average growth across the GDP’s of all nations across the world. Since global GDP is likely to be below expectations, economic activity too could be lower, thereby reducing the demand for crude oil.

2. Due to high oil prices, many countries are aggressively encouraging conservation of fuel, which has been practiced by developed and developing countries. Subsidies in developing countries have been reduced as governments continue to find it difficult to balance the fiscal deficit reducing demand for oil. Countries have also started encouraging innovation and further developing other alternative technologies like solar energy, nuclear energy for meeting its energy requirement.

3. The development of shale oil in U.S and Canada. Out of the total increase in oil output of 1. 8 million barrel per day, US alone accounts for 1.1 million barrels per day last year (source:-IEA). This is an alternate to crude oil and as its acceptance increases, the prices of crude oil are likely to dip further.

4. Increasing irrelevance of the oil cartel - Reducing market share of OPEC (Organization of the Petroleum Exporting Countries). OPEC countries market share has come down from 40% in 2008 to 32% in 2013, as developed countries have increased the production of shale oil. They have added 4.1 million barrels per day from 2008 to 2013 . The oil premium was high, and the demand supply dynamic was not as clockwork due to geo political tensions and the threat of Saudi Arabia reducing oil supplies if oil prices go below $100 per barrel. (Source Bloomberg).

5. The DXY index has risen from a low of 79 to 85.50, due to strong performance of the US economy. This index has increased by 7% in the current calendar year. This is negative for commodities, as they cannot be used as a hedge against the loss of purchasing power of the dollar.

Due to reduced market share, Saudi Arabia, Iran, Iraq and Libya have started cutting oil prices. Saudi Arabia wants to halt further production of oil from shale gas fields as continued high crude oil prices give more incentive for exploration of shale gas in the world markets.

Saudi Arabia can balance its budget with oil prices remaining at $84.50 per barrel. Its current account can be balanced even with oil remaining at $63.60 per barrel (source: - IEA, Bloomberg). The IEA (International energy association) has estimated shale gas exploration is profitable till oil prices remain around $80 per barrel. It estimates that only 3% of oil production would be affected even if oil prices fell to $80 per barrel and remain at that level (source IEA).

Oil market futures, where purchase and sale of long dated contracts over a two to five year period are trading in band of $85 to $92 per barrel (source Bloomberg).

The developed markets growth prospects are sluggish due to structural issues, high level of debts which they have accumulated over the years. Emerging markets like Brazil, South Africa, Russia and China are feeling the pressure of lower commodity prices. We expect commodity prices especially oil to remain subdued for the next 4 to 5 years as we do not expect significantly increase in economic activity in the global economy. The ability of governments to boost economic activity is limited due to the high debt level and increased indebtness of the consumers in the developed markets.

The terms of trade is expected to shift from commodity producing nations to commodity consuming nations. These developments should boost commodity consuming countries like India. The second round effect would also be felt in lower wholesale and consumer price inflation in India.

Oil Prices and You

Oil prices have a spiraling effect across the economy. If the prices of crude maintain current levels or their downward trajectory, the balance of payments situation improves, as the trade deficit comes down, improving the economic indicators of the country.

Lower oil prices could translate into transport costs going down. Therefore raw material and finished goods costs drop. If costs drop then you end up paying less for that bar of soap than you normally would. There could also be a drop in the price of fruits and vegetables, bringing the overall levels of CPI inflation down. Therefore, again, you pay less for that favorite fruit.

Due to spending less on goods and essentials, your savings could rise and therefore leaving you with enough surplus to increase your investments in the stock and fixed income markets.

Thus a fall in crude prices could lead to an overall improvement in the economy, GDP numbers and cut the trade deficit. It is estimated a drop of $10 per barrel led to reduction of trade deficit by 10 billion due to lower oil import bill. It also helps lower CPI Inflation, thereby easing the pressure of high prices on the pocket of the common man.

Above article is authored by Quantum.

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