Six reasons oil’s price plunge has shaken the markets

Malcolm Maiden
The Age
December 2, 2014

Oil is a key economic input and its price has fallen sharply. All things being equal, that’s a plus for global growth, but the markets are in turmoil. Here are six key reasons why oil’s price plunge has the markets gyrating.

THIS IS AN OIL PRICE SHOCK

In 2011, 2012 and last year oil averaged $US95.13 a barrel, $US94.15 a barrel and $US98.05 a barrel respectively, a spread of just $US3.90. It averaged $US100 a barrel in the first six months of this year and got to $107.26 a barrel on June 20. Monetary policy was still loose and the consensus was that the oil price would not move sharply in either direction.

Instead, it tipped into an accelerating price slide, to about $US75 a barrel ahead of last week’s meeting of the Organisation of the Petroleum Exporting Countries (OPEC). It hit $US66.15 a barrel on Monday, after the world’s biggest producer, Saudi Arabia, failed to back OPEC production cuts, and was still below $US70 a barrel on Tuesday despite a 3 per cent-plus bounce. Investors didn’t see the price slide coming, and haven’t worked out what it means.

AUSTRALIA IS EXPOSED

Australia is not a big oil exporter, but it is an energy exporter through its coal and LNG projects, and all energy prices will be affected if oil remains weak. Soft global demand that is playing a part in the oil price slide is also weighing on other commodity prices, depressing Australia’s export income, government tax receipts, the value of the Australian dollar and resources sector share prices.

Since the end of October Wall Street’s less-commodity-intensive sharemarket has risen about 2 per cent. Our S&P/ASX 200 index has fallen almost 4 per cent, after taking a roller coaster ride – a fall of almost 10 per cent from the start of September to the middle of October, a rally of almost 8 per cent from then to November 7, and a fall of almost 6 per cent from November 7 to now, on the back of oil’s most recent descent. Energy companies in the ASX 200 index are down 13 per cent since the end of October.

THERE ARE DEBT MARKET RISKS

By maintaining its production, Saudi Arabia might simply be forcing a production purge that is similar to the one BHP and Rio Tinto are creating in the iron ore market. It knows higher-cost producers are under more pressure to cut production than it is, and might have in its sights American shale oil producers, who have doubled United States oil production in a half a decade. Higher-cost OPEC producers including Iran, Venezuela and Nigeria might also cut production.

The US shale sector is highly geared, under pressure at prices of less than $US80 a barrel, and is investing heavily each year to maintain or increase production in the face of steep first and second-year declines in output from existing wells, a characteristic of shale oil production.

Bloomberg estimated recently that 61 oil shale companies are carrying combined debt of $US163 billion. If the oil price stays low and some cannot service their debts, high-yield “junk” bond investors would be particularly exposed. Some say it could develop into another bad debt crisis, albeit a smaller one than the mortgage debt meltdown that triggered the global crisis of 2008-2009.

THERE IS SOVEREIGN RISK

Last October the International Monetary Fund estimated what price oil-producing nations needed to break even. Iran needed $US136 a barrel, it calculated, and Venezuela and Nigeria needed $US120 a barrel. Russia needed $US101 a barrel, while Kuwait, Qatar and the United Arab Emirates needed $US70 a barrel. Even after Tuesday’s price recovery, oil is about $US68 a barrel. The national accounts of the higher-cost oil-producing countries are under considerable pressure.

THERE ARE GEOPOLITICAL UNKNOWNS

Russian President Vladimir Putin predicts the oil price will recover as the northern hemisphere winter sets in, but Russia is exposed. Oil and gas account for 50 per cent of Russia’s export income and the rouble has fallen almost 10 per cent in a week.

A less-confrontational approach to the Ukraine might ease sanctions the West has imposed, which are combining with the plunging oil price to push Russia’s economy to the brink of recession. As it is pressured by the low oil price, Iran might also be more prepared to scale back its nuclear programme to ease sanctions that are hurting its economy. However, countries that get pushed into corners sometimes lash out, and the geopolitical consequences of oil’s price slump are yet to unfold.

THERE ARE DEFLATION RISKS

Lower-energy costs usually boost economic activity, but they could create a separate problem in Europe by giving momentum to deflation, a condition that encourages economic stagnation. The governing body of the European Central Bank meets this week to discuss that conundrum.

In the United States, lower oil prices might ease inflation and encourage the US Federal Reserve to keep its interest rates low for longer. That would stimulate the US economy – or would if there was not also a shale oil corporate debt implosion.