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Tags: oil | prices | economy | inflation

Beware the Two Sides of Lower Oil Prices

By    |   Tuesday, 02 December 2014 07:09 AM EST

It’s probably not an overstatement to say that many investors encounter real difficulties in trying to predict where oil prices could be headed in the next six to nine months.

There is no doubt that lower oil prices are welcome news for consumers and that lower oil prices could help to a certain degree stimulate growth in developed as well as developing economies.

In my opinion, I would refrain from getting too optimistic too quickly for the very simple reason that global growth is slowing for structural reasons and not because of too high oil/energy prices. That doesn’t mean that any discount caused by lower oil prices shouldn’t be welcomed.

Federal Reserve Vice Chairman Stanley Fischer said at a Council of Foreign Relations symposium in New York: “The lower inflation that we’ll get from the lower price of oil is going to be temporary ... I wouldn't worry about that very much because that period of negative, low inflation is actually happening as a result of a phenomenon that's making everyone better off, and furthermore likely to increase GDP rather than reduce it.”

From his side, New York Federal Reserve President William Dudley stated in his remarks he gave at Bernard M. Baruch College in New York City: “A $20 per barrel decline in global oil prices results in an income transfer of about $670 billion per year from producers to consumers. This understates the total effect because it does not include any knock-on reductions in other energy prices — such as for natural gas — that, outside the U.S., often are linked to oil prices.” Beside that and also noteworthy was when Dudley said during a Q&A it would be reasonable to expect interest rates to rise starting in mid-2015, and when he cited a “brighter” economic outlook, with growth appearing to be running above trend. 

That said, long-term investors should also not forget the proverb that states: “Every medal has two sides.”

Coming back to oil for a moment, it’s also a fact as of late, many major oil companies have committed $1.1 trillion to projects that absolutely require oil prices of at least $95 per barrel (bbl) to generate profits.

The International Energy Agency (IEA) notes that $7.6 trillion has been “spent” on fossil fuels exploration and production since 2005, that output from conventional oil fields has contracted and that during the last three years not a single sizable project that has started production has a break-even cost price that allows oil to go below $80/bbl. Cash breakeven of shale oil production in the U.S., which varies at between $ 43 and $ 85 per barrel depending on the basin and field should be able for a good part to winter through today's prices, but there will be damage, no question about that.

Yes, many oil producers, from big to small, are facing a "debt trap" that could cause havoc in the oil markets themselves, but also much more beyond and in unexpected places in case things should turn really sour.

Once again, too much accumulated debt to extend production at any price (low interest rates thanks in part to the quantitative easing undertakings of the Federal Reserve and others) can put literally anybody in huge difficulties when they are obliged to sell well below their planned break-even prices.

For those who still should be interested in investing in oil now, I’d prefer to limit my choice to one of the what’s called the “majors,” which are BP (UK), Chevron (U.S.), ExxonMobil (U.S.), Royal Dutch Shell (The Netherlands and UK), Total (France) and ConocoPhillips (U.S.), with my personal preference still for Royal Dutch Shell.

I wouldn’t enter oil-related investments now as I’d prefer to wait until there is real trouble in the markets, which could come in the future. Yes, I have learned always to try to step in when there is panic, which is certainly not yet the case today. I’d prefer to remain patient and wait.

A first sign that could hint oil prices are bottoming out is the moment when the present abnormal “contango” futures prices return back to the normal “bacwardation” futures prices. Contango is a situation where the futures price or forward of crude oil is higher than the spot price and that’s when hedgers, arbitrageurs, speculators, etc. are willing to pay more for a crude oil at some point in the future than its actual spot price.

Oil futures prices are in “backwardation” when the futures prices are below the spot price, which is considered favorable for investors, speculators, etc. who have long positions since they want the futures price to rise.

Of course, we aren’t there yet, no, not by a long shot.

Last week we witnessed one of those historical moments when OPEC’s “swing” producer Saudi Arabia signaled a new era of oil price competition that now has left the oil market firmly in thrall of weakened global demand. Such weak global demand was, by the way, confirmed by the JPMorgan Global Manufacturing PMI that came in at 51.4, a 14-month low, but that nevertheless indicates globally we're still growing, albeit merely. Yes, it becomes time this downward trend reverses.

Also for the investor, as well as for various central banks who have the task of maintaining price stability, there is a problem developing that should not be underestimated. That problem is if there is a further slide in crude oil prices, it won't only directly accentuate the downward pressure on consumer price indices across the G-20, but also the prevalence of disinflation could become sustained by lagged, indirect effects when cheaper oil finally starts filtering down the production pipeline.

Yes, that’s thin ice territory.

As said here before: “Every medal, which includes the one of substantial lower oil prices, has two sides.”

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“Every medal, which includes the one of substantial lower oil prices, has two sides.”
oil, prices, economy, inflation
Tuesday, 02 December 2014 07:09 AM
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