Conventional wisdom tends to associate sharp increases in oil prices with economic chaos and sharp declines with significant economic benefits.

The latest oil price shock: is this time different?

Just recall how the global economy suffered during the Arab oil embargo and the Iranian revolution in the 1970’s. On the other hand, consider the broad benefits enjoyed by the majority of countries during the “oil glut” of the eighties.

Currently, the price of crude oil stands at around $43 a barrel (WTI crude), which means that it is about 70% lower in comparison to its pre-global financial crisis levels. Actually, over the past decade, the norm was a price of $90-$100 per barrel. This decline should have been ф reason to cheer; a timely boost for the global economy, which is still trying to recover fully from the 2007/08 financial crisis.

Alas! This time it appears to be different as the “benefits” of the recent “oil glut” appear not to be so certain.

What’s going on with the oil prices?

The reasons behind the fall in oil prices, though complicated, can be attributed to simple economics: supply and demand shocks!

On the supply side, Saudi Arabia is producing at very high levels, in an effort to “corner” smaller, high-cost producers in America and elsewhere. This reminds us a bit of the eighties, when the OPEC countries employed similar “tactics” to undercut producers in the North Sea, without much success. Staying on the supply side, we also have the return of Iranian oil in the world markets, after the lifting of international sanctions last January. This is probably something the world could have done without, at least at this point in time, especially given the rivalry between Iran and Saudi Arabia.

In addition to all this remember that the United States has been steadily increasing its production over the past several years and Russia, another major producer, has not cut its production.

On the demand side, given the slow-down of China (the demand “shock”), the growth of the global economy appears to be “anaemic” at best, hence not in a position to absorb supply.

So, who are the “winners” and who are the “losers” from this latest chapter in the long history of oil shocks? It is not surprising that the “winners” are the countries that import oil, such as Germany, Britain, Spain, Italy, and especially India and China, who have received a strong and much needed economic boost.

On the other hand, the “losers” are countries where oil exploration and production occupies a central role in their economies, such as Saudi Arabia, Russia, Brazil and Nigeria. The effect on other countries, such as the United States, who are both producers and consumers, appears to be much more ambiguous, though critical.

An intriguing and potentially worrying development of the recent sharp drop in oil prices has been its effect on financial markets.

There are two things that we should note here.

The first is related to the investment side and has to do with the fact that, given the “option like” characteristics of investment in oil reserves, as oil prices fall, exploration and investment in such projects is likely to go down.

The second has to do with the fact that, given near zero interest rates in developed markets after the financial crisis of 2007/08, vast amounts of global capital have flown to emerging markets. A large portion of this capital has gone to companies in the oil industry, who may find the servicing of such capital quite difficult, given falling prices hence revenues. This latter effect, given the globalisation of financial markets, could lead to an increase in the level of risk aversion among investors – which can spread from energy companies elsewhere – and which could affect both international bond and equity markets.

Last but not least, the latest “oil glut” has an important political dimension too.

Remember that it “touches” rather “delicate” parts of the world such as the Gulf region, Russia, Venezuela and Colombia, among others. The point here is that falling revenues are likely to lead to lower economic growth, depreciation of the local currency, imported inflation and tighter monetary policy.

What’s next?

To recap then, main oil producers such as the US, Saudi Arabia and Russia, each for their own reasons, continue producing and stockpiling. Add to that the return of Iran in the market and we could be having the “perfect supply shock”.

On the other hand, monetary tightening in the US and elsewhere, along with a renewed sensitivity towards environmentalism, means that demand is unlikely to absorb supply for quite some time. This could mean that oil prices are not likely to rise soon. It could also mean that the world needs to be careful so as not to get “drowned” in cheap oil!

What do you think about the recent oil price developments? Let me know what you think in the comment section below.

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