As a few of my colleagues on TradingFloor.com have pointed out, it’s dire times for oil producers and the countries that depend on decent prices. As my esteemed colleague and TradingFloor.com deputy editor Clare MacCarthy pointed out here (as did our Russian oil expert Nadia Kazakova) OPEC’s decision could be seen as a strategic move by the Saudis to eat into Russia’s global market share. As McCarthy noted: “If successful, this tactic (which could also impede the United States’ new-found shale success) could give the OPEC countries a leg back up towards the virtual monopoly control of international oil markets they’ve enjoyed since the 1970s.”
Read the same with Australian (and to a lesser extent Brazilian) iron ore producers, overproducing in the midst of a world glut of the red metal. Like the oil producers, they’re currently engaged in a race to the bottom. Whoever gets to the bottom of the oil barrel (literally) and still survives, will have bragging rights from here on. It’s the US shale producers versus OPEC. They don’t care about the rest. As far as they’re concerned, the rest can go take a bath (for want of a better expression).
But with all the news about the plummeting price of oil, I couldn’t but feel a bit elated. After OPEC decided against cutting output despite a huge oversupply in world markets, I wondered about the ramifications. Here is Brent crude oil plunging as much as $6.50 a barrel on Thursday, and US crude dropped by nearly as much, posting their steepest one-day falls since 2011.
Lower oil prices may be the ignition switch needed for US and China to kick-start things again. Photo: Thinkstock
Oil prices have fallen by more than a third since June, as increasing production in North America from shale oil has overwhelmed demand at a time of sluggish global economic growth. Crude prices have been falling all week as traders and analysts scaled back expectations of an OPEC production cut, but the sharp dive after Thursday’s meeting showed the decision was not fully priced in.
But do we want to go back to the $100 plus barrel range? At this level, economies are seriously hampered, if not damaged. Most of the ways businesses can work around high oil prices involve reducing wages to workers – for example, outsourcing production to a lower cost country, or cutting domestic staff to match lower demand for goods. The cost of food rises because oil is used in many ways in growing and transporting it, and partly because of the competition from biofuels for land, which drives up land prices.
The cost of shipping goods rises. The cost of materials that are made from oil, such as plastics and chemicals, also lifts. If salaries aren’t rising and people are being laid off – while prices of many types of goods and services are shooting up, then there’s a serious disconnect. What happens? There’s likely to be a long-term cut back in discretionary spending. When oil prices are high, there is lower demand for goods and businesses raise their prices to reflect higher energy costs.
What flows from this? If the upward pressure on prices is not accommodated by the monetary authority, it will lead to negative demand effects, causing actual output to fall. A supply-side shock in the oil price may also induce a slump in demand, which becomes more ingrained if the oil price spikes for a significant period. A permanent fall in potential output is likely to generate pessimistic expectations of future income and wealth. As consumers cut back on spending, the declining real rate of return on investment will prompt firms to invest less.
Businesses are more likely to close when oil prices rise. Those businesses are often replaced by companies in China or India with lower operating costs. These lower operating costs indirectly reflect the fact that the companies use less oil, and third world workers are paid less. Ergo, less employment in first world countries. Governments may then have to pay out higher benefits than in the past, just to keep the economy afloat. The situation becomes unstable, because very low interest rates depend on some form of quantitative easing, which in the US at least, is ending. Thus, interest rates will need to rise, and taxes will need to be higher (to cover the government’s higher debt costs) and the inflationary cycle we all despise starts all over again.
So can’t we now see the lowering oil price as a boon? It may be the ignition switch needed for US and China to kick-start things again – they’ve tried to engineer lower interest rates and quantitative easing to get things happening, but maybe the lowering oil price is the cue from which to build. It will at least give them a leg-up to bring back consumer demand.
The question then becomes – who are we rooting for? Stronger and more vibrant economies based on low oil prices, or the highly damaged oil companies – and oil-based economies – that will suffer from this race to the bottom of the barrel? Do we want high oil prices or low? I was always taught from an early age that a price war only benefits consumers. So I’ll take the low road, thanks.
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