Question

Falling Oil Prices and their Long-term and Short-term Impact on the Ordinary Investor

write a report at least 2000-2500 words.

Answer 1

Effects of falling Oil Prices- it's Long-term and Short-term Impact on the Ordinary Investor

Effect of falling oil prices

A fall in oil prices should cause a reduction in transport and fuel costs for firms. Consumers who will also benefit from the lower prices of transport and fuel. The lower oil prices will effectively increase their disposable income and enable them to spend more on other goods

Because oil is the most traded commodity and has a significant bearing on global transport costs, it should lead to inflation and can lead to higher rates of economic growth.

However, sometimes oil prices crash because there are fears of an economic recession. In this case, falling oil prices are not sufficient to increase economic growth because other factors keep growth low. Also, if oil prices fall sufficiently, it can cause some oil firms to go out of business and this causes a rise in bad debts. The crash in oil prices in 2020 is indicative of the economic recession and prices have fallen so far that many oil firms will be forced out of business, causing job losses and falling investment.

Also, falling oil prices will have differing effects depending on the country. Oil importing countries (e.g. Germany, Japan, India) will generally benefit from oil lower prices, but developing economies who rely on oil exports (e.g. Russia, Venezuela) could see a significant fall in export revenue.

Usually, a fall in oil prices would be greeted by consumers and firms due to the lower prices and costs. However, this fall is due to expectations of a sharp drop in travel and economic recession from the coronavirus. Therefore, there is little expectation that the lower oil prices will have any positive economic effect. If people cut back on travel, cheaper petrol doesn’t make much difference. If people see a fall in income because they are out of work, cheaper oil prices are only a small compensation.

Companies that benefit from low oil prices?

Peer Companies:

Oil marketing companies such as IOCL, BPCL and HPCL are likely to benefit from low oil price given the reduction in refinery fuel loss and potentially higher auto fuel marketing margins.

Impact of lower oil prices on oil consumers:

Lower oil prices help to reduce the cost of living. In particular, if a household owns a car or uses other forms of transport reliant on oil. To a lesser extent, all goods should become cheaper due to lower transport costs.

This fall in the cost of living is especially important if real wage growth is low which has been the case in recent years. A fall in oil prices is effectively like a free tax cut. In theory, the fall in oil prices could lead to higher spending on other goods and services and add to real GDP.

Oil importers will benefit from a falling oil price because the value of their oil imports will drop. This will reduce the current account deficit of oil importers; this is important for a country like India who imports 75% of oil consumption and currently has a large current account deficit. However, for oil exporters, a falling oil price will do the opposite reducing the value of their exports and causing lower trade surplus. The UK is currently a small net importer of oil, so will have a limited impact on UK current account.

Oil Exporters

For oil exporters, a fall in oil price is damaging to the economy. Many oil-exporting countries rely on tax revenue from oil production to fund government spending. For example, Russia gains 70% of all tax revenues from oil and gas. Falling oil prices will lead to a government budget deficit, and will require either higher taxes or government spending cuts. Other oil exporters like Venezuela have relied in the past on oil revenues to fund generous social spending. A fall in oil prices could lead to a significant budget deficit and social problems.

Other oil exporters, such as Saudi Arabia and UAE have built up substantial foreign currency reserves; they can afford temporary falls in oil prices because they have substantial reserves.

Reduced profitability for alternative energy sources. In recent years, there has been an incentive to invest in renewable energy and electric cars. A prolonged fall in oil prices will reduce this incentive and encourage firms and consumers to stick with oil.

Falling oil prices could delay investment into alternative ‘greener’ forms of energy, such as electric cars, and this could have negative consequences

Long-term falling oil prices could reverse the recent decline in-car use, leading to a steady increase in traffic congestion and environmental costs of petrol use.

Starting with the nature of the oil price decline, two aspects are critical.

· Underlying drivers of the price decline. Lower oil prices can be a cause driving global economic activity or a response to other shocks driving global growth. In the former, the decline is driven by factors not related to current global economic conditions, say changes in oil supply due to technology. In the latter, the lower prices would be a symptom of other unexpected changes to global economic activity, including, for example, a demand shock in a major economy with significant spill overs to many other economies. Identifying the reasons for the oil price decline is thus critically important for assessing its likely global economic impact. Section II on oil and other energy prices suggests that a large share of the recent oil price decline likely more than one-half was due to supply factors.

· Persistence of the oil price decline. The effects will also depend on whether the lower oil prices will be temporary or permanent. If temporary, the real income gains (which accrue mainly to the private sector in advanced oil-importing countries) will mostly be saved or, in the case of real income losses in oil exporters (which accrue mainly to the public sector), borrowing will increase. If permanent, spending patterns will need to adjust. The persistence of the oil price decline will depend importantly on the underlying drivers, as well as the adjustment in oil markets to the unexpected decline in prices. Technological progress shifting oil supply, for example, usually results in permanent price changes. But there might be feedback effects, including through investment in oil exploration and development, partly offsetting the longer-term oil price impact. Section II notes that a substantial part of the oil price decline is expected by market participants to persist into the medium term, but there is considerable uncertainty

Factors affecting oil prices in short and long run:

This long term rise in oil prices could still see oil prices fall in short term due to the Euro debt crisis. But, in the long term, the price of oil is determined by ‘fundamentals’ the long term growth in supply and demand. Long term oil prices are likely to rise if:

• We experience a growth in world population.
• Economic growth leads to increased use of oil.
• Given the rate of economic growth in China and India, there is the potential for a very rapid increase in demand for oil – especially if we don’t find alternative energy sources.
• Given the predicted rise in demand, it is highly unlikely supply will be able to keep pace. Oil is a finite resource, as we consume more, it will become increasingly difficult and expensive to extract oil prices.

Short Term Factors.

• Oil is the most commonly traded commodity. The price of oil is highly volatile reflecting short term shifts in demand.
• If the global economy, fell into a double dip recession then we would see a fall in demand for oil and therefore its price would decrease. As the articles suggest, the fear is that a Euro debt crisis could lead to a prolonged recession in not just Europe, but other countries; this would cause a significant fall in demand for oil.
• However, when the global economy recovers, you would expect a reversal of this trend, and we would expect to see a sharp increase in demand for oil pushing prices higher.
• OPEC has some ability to influence prices by setting output quotas. Certainly, if Saudi Arabia decided to significantly increase supply, we would expect oil prices to fall. However, the impact of OPEC has declined since the 1970s, when they were able to treble prices in a few months.

Why the demand for oil increase, even with higher prices?

· Demand for oil is a normal good (it may even be income elastic). When income rises there is a bigger percentage increase in demand for oil. This is because:

· Oil/petrol is a necessity for transport. Thus with economic growth, demand for petrol rises. High economic growth usually pushes up the price of oil, but, people are willing to pay the higher prices because of the economic growth.

· During 2008, the price of oil fell because of the slump in demand.

· There is a both an income and price effect for oil. If real incomes remained constant, higher prices would reduce demand, but, generally real incomes rise at the same time.

· Higher price will ceteris paribus reduce demand. But, the reduced demand from higher prices may be outweighed by rising incomes. This can be applied to many other goods as well.

Investors:

Investors always pretend to be interested in the macro trends of the world, while in their hearts, they simply love to make the next quick buck. oil without complicating it with too many numbers and details.

There are at least three points of view around the falling oil prices. The first one is cruel. It simply extends the current falling trend to ludicrous levels. Some are now saying that $10 a barrel is likely. Never forget that some called a price of $150 a barrel in 2008 and bit dust. No one can predict price levels. The second view is that the prices have fallen so much that they must now rise. This one is patently dishonest and not easily actionable. It can be true at $60 a barrel as it is at $30. Buying at $60 would have wiped out the position by 50% even as we speak. The third view is that everything will be fine in the long run, and that investors with a high risk appetite and time should take advantage of the crisis. This is a convenient recommendation that wards off those who ask innocuous questions. It is actually smug and useless.
Price is simply a function of supply and demand, and both sides of the equation evolve dynamically in the marketplace. The demand for oil depends on a large number of buyers, many retail, spread all over the world. The lure of oil is widespread and there is an insatiable demand for the commodity that might be somewhat limited in supply. Even as we speak, so many economies are growing so slowly that the demand is poor. The supply side comprises large producers and many of them also form an organised cartel called OPEC. Shale gas producers are the new suppliers trying to chip away at this cartel.
If prices keep moving up, consumers will cut back, find substitutes, invest in public transport and do their bit to maintain sanity. Suppliers will gloat over the high price and, taking advantage of their oligopoly, restrict supply to make the most of the situation. When prices fall, consumers will be gleeful and buy more, but suppliers will feel squeezed, cut back on production and resort to layoffs.
The swinging prices also impact investment in oil and return on this investment, which is the starting point of a commodity cycle. At high prices, it is very profitable to discover oil, invest in new fields, finance innovations in shale and expand capacity. It is expensive to find, extract and transport oil. Investments, therefore, are made on a large scale and by financially strong entities that can wait for the time it takes to build capacity. A sustained increase in price is necessary for this activity to remain viable. When prices fall, there is a double whammy lack of demand and piled up inventory that is now worth so much less.
The new price for oil will depend on supply and demand as dynamically altered by both sides. As long as oil producers have an inventory that they cannot sell, price will remain low. If we add to this equation the falling demand from China, slower global recovery, new supplies from Iran and all such news items with confirmatory bias, we can write an analytical report for the next new low in oil prices. The markets will expectedly overreact to such news.
The next high is, therefore, unknown. This is not just because we cannot blindly use historical prices, but also because we would not know the new levels of supply that will hit a revival in demand. When the inventory runs out and demand begins to firm up, prices will look up. If there is a new level of supply and demand, there will be a new price. From $20 a barrel, $60 will be a new high. The problem is that this cycle of demand recovery, clearance of inventory and the return of pricing power will not happen in a few days or weeks. This is one commodity cycle that will play out from the unknown bottom to the unknown top, and post-mortems never made any money for anyone.

The investors who are tracking the supply side intently will know when to enter the market. In a bottom, it is the painful shrinkage of production capacity that holds the key to future pricing power. This is a strategic call for oil producers and they will struggle through lack of demand while they make it. Cutting back on production and low capacity utilisation will reach a new low to enable the cycle to turn. It then has to be helped by a revival in demand. Staring at market prices will hold no clue to this recovery.

Long Term Investors:

Commodity calls are not for strategic long term investors, who buy and hold and may not track supply and demand closely. The brave ones who come now will be disillusioned with the lack of upside action; and others will wait so long for confirmation that they will come close to the top. The long-term investors, who take part in a bleeding commodity market braving risks and make pots of money in a recovery, are perhaps works of fiction. Tactical and opportunistic calls are what commodity trades are made of.

Few Gains for Equity investors:

Though the crash in crude is good for the economy, it is not as good for the stock market. In fact, the stock market goes up when crude is at higher levels and falls when crude is at lower levels.