Sunday, 14 December 2014

Oil price crash

The black gold, or to be precise, fluctuations of its prices, have had a substantial impact of world’s economic history in recent decades. Surges in crude oil prices plunged economies into recessions or exacerbated economic downturns which were about to come to a pass, yet on the other hand helped the resource-rich grow their fortunes. Oddly enough, the price of crude oil was very volatile in its history, implying quotations of the commodity have been prone to overreact to variations in fundamental factors driving oil prices.

Brent crude oil quotations over the last decade saw period of both stability and volatility. The rapid increase set off in 2007 and then price soared in the first half of 2008. The underlying of the 2008 rally still remains puzzling to me. In early- and mid-2008 the banking crisis began to unfold and monetary policy in most economist was already tight, in response to partly oil-driven inflation. Bear markets took over on almost all stock exchanges in the world, as equities already anticipated the imminent economic misery (but not its scale). The only asset classes to have stayed immune to the turmoil were emerging markets currencies (upshot of carry trade) and… commodities. The collapse of Lehman Brothers Bank in September 2008 spilt over to both financial markets and real economies and incited speculators to unwind their long positions in emerging market currencies and commodities. Both assets classes saw their valuations plummeting. As a consequence, Brent oil price fell from 148 USD per barrel in July 2008 to less than 40 USD in late December 2008. Over the next months, in the wake of unprecedented monetary easing, financial markets were flooded with hollow money and oil quotations rebounded. Since late 2010 until September 2014 Brent crude oil traded in a fairly stable range between 100 and 120 USD per barrel… The was no bubble in sight, so no bubble could burst.

In mid-September 2014 one still had to pay almost 100 USD per barrel, but in the second half of the ninth month quotations started to decline. At first drop in oil price was offset by appreciation of the US dollar. Since the correlation between the two assets is highly negative, the first explanation for drop in oil price was the strengthening of the American currency, buoyed up by the relative out-performance of the US economy. Then the scale of the plunge only got deeper. Currently, the 3-month rate of return reached –37%, justifying even the use of word ‘crash’ to describe this downward price movement.

There are several theories and factors which are said to be have contributed to the sell-off of the black gold. One could mention:
(1) increasing supply and inventories,
(2) lower dependence of the US economy on imported oil,
(3) discord between OPEC members, unwilling to cut extraction,
(4) a “conspiracy” aimed at enfeebling countries reliant on oil exports,
(5) unwinding speculative positions and taking opposite ones.
The last cause cannot be played down when analysing the recent panic-driven continuous slide.

A sudden drop in oil prices is a classic example of positive supply shock; an external factor which, holding everything else unchanged, should boost the economy. Price of crude oil is a component of price of virtually any other good, so a drop in Producer Price Inflation should result in drop in Consumer Price Inflation and in current macro environment in intensified deflation. Because producers will definitely try to seize some of the decline, their profits should rise, increasing investment spending, consumption, but remain neutral for government proceeds (higher corporate income tax inflows to be offset by lower VAT inflows). Lower oil prices will also be passed on to customers whose discretionary income will rise; they in turn will be able to spend or save more.

A place where decrease in oil prices is most visible are petrol stations. Back in mid-2012, one had to fork out almost 5.90 PLN for a litre of unleaded-95 petrol. The price of the same petrol crossed the barrier of 5.00 PLN in the third decade of October (my benchmark is the local petrol station by Auchan hypermarket) and descended to 4.39 PLN this weekend (down from 4.61 PLN last Tuesday). The decline grew apace when USD/PLN quotations levelled off between 3.30 and 3.40 and after the last week’s 8% plunge there is still room for petrol prices to go down and nearing the 4.00 PLN barrier is conceivable, albeit it would take a further sell-off in London, where Brent is traded.

Oil producers profit and loss accounts will suffer a one-off shot of downward inventory revaluation (reported as cost of goods sold under IFRS), however their long-term profitability should not be undermined, since it hinges upon different factors (margins earned on refining and differentials between types of oil, for Polish oil behemoths, PKN Orlen and Lotos, spread between Russian Ural oil and Brent oil) and those parameters have been enormously favourable for the oil industry in the recent weeks.

Disinflation or deflation spurred by fall in oil prices is an external factor and as such should be cautiously taken into account by central banks in their decisions on pursuit of monetary policy. Drop in oil price must not give rise to monetary easing, since the very decline in oil prices already bolsters economies and seeking excuse in prolonged deflation to further cut interest rates is adding fuel to the fire rather than fostering economic growth. Nevertheless, plunge in oil prices may prompt the Federal Reserve to put back monetary tightening. For no apparent reason, stock markets’ reaction to oil crash was underperformance (although only the oil and gas industry might be actually aggrieved) and since unsurprisingly the US Central Bank has recently targeted financial markets more than real economy, policy of near-zero interest rates might be kept up in a horizon of more than a few months.

One of not implausible explanations for the oil price collapse is the US-steered conspiracy to afflict Russia. It somehow takes my fancy, although I will not dare to guess how much truth is in it. Economic sanctions imposed on Russia, by nature ludicrous since they hit more the West, only uncover a free-market failure. Had the sanctions not been in place, trade between Russia and Western entrepreneurs would have thrived, heedless of Crimea invasion and war in Eastern Ukraine. But when Russia suffers on account of balancing supply and demand and free market mechanism lays bare Russian economy’s reliance on resource exports, I judge matters fall into place. I personally favour more sophisticated economic weapons than simple trade restrictions.

And having said all that, I confess plead I am not particularly delighted to observe Russia being knocked down by low oil prices (the scale of disaster is offset by unmatched depreciation of Russian Rouble). Russia faring well was less perilous to the world than Russia economically kneeling. The less Mr Putin has to lose, the more unpredictable political bets he will be inclined to make to shield his rule and underline supremacy of Russia in world politics might be.


Michael Dembinski said...

Using very little petrol (one trip a week to the shops and a motorbike that sips 2.3 litres to 100km), I'm not that fussed whether a litre of 95PB costs 3 zlotys or 6 zlotys.

But the impact of 3 x 63 (63 roubles to the dollar, 63 dollars per barrel of oil, and Mr Putin's 63rd year on earth) will have on Russia is intriguing. Conspiracy? Why of course, the powers-that-be are pulling in all sorts of favours with the Saudi, Iraqis and Nigerians to ensure that production is full-on... In terms of demand-side, OK, the eurozone and Japan are languishing, but elsewhere around the world, there are signs of life. I can't see a natural cause for such a dramatic price crash in such a short space of time...

The problem in Russia is that Putin has spent 15 years removing any potential opposition to his reign. When Russia implodes, there will be no one to pick up the pieces. Messy.

student SGH said...

I'm more concerned since kilometrówka is fixed and I happen to drive more for business than private purposes - more left in the pocket and deducting cost of petrol and motorway tolls.

It's not just the infrequent use of car (you count in only your trips, leaving out your wife's) or motorbike that affect your household's spending. Whether the fuel costs 3 or 6 zlotys has a noticeable impact on inflation.

Three times sixty three scenario has just materialised. Inside, Russia is falling apart, but it is determined to keep a bold face. Russian people, fed by propaganda and seasoned in lasting out misery, will persevere another period of austerity.

But look at this. When in mid-September oil stood at 100 USD/bbl and Russian Rouble could buy 38 dollars, one barrel of oil was worth 3,800 Roubles. Today oil stands at 61 USD/bbl, USD/RUB appreciated (RUB as base currency) to 63, one barrel of oil is worth 3,843 Roubles. So in terms of oil only, the oil price crash was fully offset by domestic currency depreciation. Such indifference does not come into play when it comes to imported goods.

And even if there was opposition to take away power from Putin, how would it be capable of turning around the Russian economy? Lack of democracy is one of many problems of Russia...