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Oil prices have driven markets in 2015
Lorenzo Ippoliti, Milán
Oil prices have definitely been one of the most important factors driving global financial markets during 2015. The purpose of this note is to briefly describe current oil market dynamics and their effect on markets.
Brent crude prices fell almost 70% from the June 2014 peak of 115 USD a barrel to 36 USD a barrel last Monday, the lowest price in more than 11 years.
What is pushing prices down?
Among the factors currently affecting the oil market we can mention:
- Strong increase in US oil and gas supply. Thanks to advances in the technology used to extract oil and gas from shale rocks (shale revolution), US oil production has risen to 9,3 million barrels per day in 2015.
- Imminent lifting of sanctions on Iran. This country has the fourth largest oil reserves in the world. Markets are discounting that a significant increase in Iranian oil exports would put further downside pressure on oil prices.
- Price war engaged by OPEC countries in order to defend their market share. Low prices would make higher cost oil production (such as the shale production) not economically viable. In their December meeting, OPEC members, led by Saudi Arabia, decided not to cut production levels and oil prices cratered by a further 15% after the meeting.
- Increasing global growth concerns. China’s economy seems to be slowing down with many analysts forecasting a hard landing scenario, Europe is still weak and an emerging markets debt crisis may be looming.
- FED end of zero rate policy expected to further boost the dollar. Commodity prices and the US dollar usually show an inverse relationship. The prolonged strength of the dollar is putting pressure on commodity prices.
- Growing environmental concerns. With the Paris Agreement governments pledged to limit the global warming to 1.5 degrees and committed themselves to come up with plans to reduce emissions.
- Above average temperatures. This year’s climate appears to be quite warm in most of the Northern hemisphere further depressing oil consumption. The absence of rains also increases air pollution levels in the largest cities around the world pushing governments to adopt measures to improve air quality.
In the present context supply factors are playing a prominent role in driving oil prices lower. The situation is different from the 2008/2009 demand-driven collapse.
How can the oil price fall affect the global economy?
When the price of oil falls there is a transfer of wealth between oil producers and consumers. The net effect of a supply driven fall in oil price is deemed to be positive for the global economy (a demand-driven fall in oil price would be different as it would entail lower prospects for growth).
Data from the past suggest that a 30% decrease in oil prices should boost global GDP by around 0.5%.
However, despite its potentially benign effect on economy in the medium term, the free fall of oil prices is currently perceived as a destabilizing factor for international financial markets, causing spikes in volatility and shaking risky asset prices around the world.
Why falling oil prices are a cause of concern for investors?
Among the reasons explaining why such a rapid fall in oil prices is causing concerns among investors and it is not boosting global economy like forecasted by most economic models, we can mention:
- Low oil prices for a prolonged period of time would increase deflationary pressures in a period in which central banks around the globe are running out of weapons to fight deflation. Deflation is deemed to be bad for the economy because consumption and investments are deferred on expectations of lower prices in the future. Deflation also worsens the situation of debt burdened countries as it increases the real value of debt.
- Structural changes in the shape of the economic activity are reducing the impact of oil prices on GDP. Among these structural changes there are the reductions in the relative weight of energy-intensive economic sectors and increased labour market flexibility.
- Low energy prices cause a decline in energy related investment around the globe and a fall in direct employment in the sector.
- Countries and corporates whose revenues depend on oil are experiencing an increasing credit and refinancing risk. Government bond spreads of oil producers have widened and local currencies have depreciated. The stress in the energy sector has caused liquidation of high yield bonds in the US resulting in worrying developments such as Third Avenue fund blowout.
Will oil market fundaments change in 2016?
Oversupply is probably going to persist in 2016 putting further pressure on prices. IMF predicts that oil prices could go as low as 20 dollars per barrel next year on increased Iranian supply.
What events could change oil market dynamics?
Among the potential developments that could lift oil prices at least in the short term there are:
- A production cut by OPEC members. Further price declines and the deterioration of the fiscal and external positions of some of the more exposed members could force OPEC to finally cut production.
- A short squeeze of the massive speculative short positions accumulated. With prices close to the support given by previous 2008 low and short positions at record highs, oil market seems to be exposed to a possible short squeeze.
- An increase in geopolitical tensions. Conflicts in the Middle East could result in disruptions of oil production and/or restrictions being imposed on exports.
- China’s slow down proving to be less severe than anticipated in the hard landing scenario. This would certainly give a boost to battered commodity prices.
About Lorenzo Ippoliti
Lorenzo Ippoliti is a proprietary trader with 20 years of experience mainly in Forex and credit markets. He has worked for some of the major banks in Italy. Lorenzo holds an MBA for the SDA Bocconi School of Management.
The investment estrategies integrated in our diversified portfolios and our customised portfolios have been designed to have a reasonable good performance in any market situation.
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