Low Oil Prices – Feeding the Addiction

Cheaper oil will bring about much cheer but it will help keep key oil producers happy in years to come

Oil is like a drug that the world economy cannot do without and we are in the midst of a turf war over who will call the shots.  A few dealers have had a stranglehold over the market for oil and have been able to set prices as they please.  The arrival of new kids on the block (with the rise of fracking in the US) has triggered a fight for control of the oil market.  The result has been a plunge in oil prices which is a blessing for the global economy but is part of a bigger strategy to keep us all addicted to oil for years to come.

Not a buyers’ market

The sharp drop in oil prices will provide a welcome boost to the economic recovery in many countries.  Oil is like a drug in that it is always in demand and buying continued despite high prices in the aftermath of the global financial crisis.  Prices for oil have only recently eased off (playing havoc with inflation) as demand from energy-hungry China has weakened while supply from the US has expanded.  Oil is also plagued by a further similarity to drugs in that the suppliers of oil tend to be some ugly characters such as Russia, Iran, and Venezuela (as well as some nice ones such as Canada and Norway).  But the kingpin of the oil market is Saudi Arabia due to the size of its reserves of oil and its willingness to adjust its output to market conditions.

Saudi Arabia is the top dog of a club called OPEC where some of the major producers of oil banded together to wrestle control of the oil market away from Western energy firms.  OPEC came to prominence in the 1970s when the countries cut oil output as a protest against Israel.  Along with the devastation wrought due to the resulting surge in oil prices, efforts to conserve energy also acted to weaken the need for oil.  Once oil prices returned to normal, OPEC has looked to set its output so as to make the most money while also suppressing incentives to cut back on oil consumption. 

Sticking to the optimal level of output was always going to be tricky when cheating would bring in extra cash.  This meant that not all members of OPEC stuck to their quotas set to manage the supply of oil and it was left to Saudi Arabia to shoulder the burden of larger cuts to production when required.  Saudi Arabia could pull this off due to its revenues from oil being more than enough to fund its government spending.  In contrast, governments in countries such as Venezuela and Iran spend big to support their anti-Western antics which tend to max out the cash from their energy sectors.

Trying to stay on top

The arrangements behind this oil cartel have been bust wide open due to the surge in oil output coming out from the US.  New fracking technology has unlocked previously inaccessible oil reserves and turned the US into a big player in the oil market.  Faced with a choice of cutting its output or suffer falling prices, OPEC chose the latter.  The Saudis, in particular, were not willing to take a hit and lose out in terms of market share.  As Saudi oil is typically cheap to get out of the ground, their hope is that a lower price for oil will drive others out of business.  A drop in oil prices will also scare away any investment in oil fields that would boost output in the future.

It pays for Saudi Arabia to take a long term view of the market seeing that it has so much oil still underground.  An abundance of new sources of oil or new technologies that eliminate the need for oil would take a big chunk out of the value of its underground stash.  Saudi Arabia is in a strong enough position to sacrifice short-term gain to lock in future control over the oil market.  Be thankful that the Saudis want oil to be cheap for now and keep us all addicted but don’t expect it to last (much more than a few years).

Inflation – Hard to ignore again

Low inflation is a nuisance for central banks looking to increase interest rates but they would be wrong to dismiss it

Family get-togethers over Christmas often involve naughty children but it is inflation that is making trouble for central banks.  Inflation unexpectedly shot up in the aftermath of the global financial crisis but is now surprisingly falling despite a burgeoning economic recovery.  Central banks ignored the jump in inflation in 2011 and are now stuck figuring out how to deal with persistently low inflation.  The antics of inflation will be difficult to disregard a second time around considering that the causes for static prices are not all external.

Inflation acting up

The level of inflation is used as a measure to check whether all is well with the economy.  There should neither be too much inflation (suggesting an overheating economy) nor too little (which is a sign of weak overall demand).  With countries increasing sourcing goods from overseas, prices levels in any country can be influenced by prices of commodities on global markets.  This can push inflation in a different direction to the particular circumstances of any economy.

The best recent example of this was a plague of high inflation in 2011 when the economies of many countries were still in the doldrums.  The Chinese economy was still humming along despite financial turmoil elsewhere and China continued to buy up commodities on the global markets.  The result higher prices were most prominent in the UK where inflation topped five percent in 2011.  This bout of inflation was not just a brief spike with prices rising by more than four percent for over a year.  Despite inflation being well above its target of two percent, the Bank of England maintained its loose monetary policy to support the weak economy.  The argument behind this was that the inflation was temporary and not related to the underlying economy. 

Behaving badly again

Inflation is currently misbehaving in a different way and is causing concern due to being too low.  Prices are not rising by much due to lower commodity prices with the spurt of growth in emerging countries having run its course.  While this is a positive for consumers who benefit from a boost in spending power, low inflation is a source of anxiety for central banks.  The Federal Reserve and the Bank of England are getting set to increase interest rates to more normal levels.  Even the prospect of the economic recovery gaining further momentum would not provide central banks with enough of a reason for higher interest rates when inflation is around one percent. 

This irritation is not likely to go away anytime soon if the high inflation in 2011 is any guide.  Inflation is likely to slip even lower in 2015 as the effects of the plunging price for oil feeds through into the economy.  On top of this, swings in commodity prices tend to last for a few years so that inflation is unlikely to pick up for the next couple of years.  This would suggest that inflation will be below target for 2015 and 2016 which is the two-year time frame that central banks look at when deciding interest rates. 

Ignoring inflation would be naughty

Low inflation should imply low interest rates but central banks could choose to ignore this and raise interest rates away.  This is because the same argument as in 2011 could be applied – disregarding trends in inflation that are attributed to outside sources.  It is a convenient strategy for central banks worried about the economic recovery triggering a jump in inflation due to the potential for wages to rise as unemployment falls.  Such an outcome does seem optimistic considering that wages are not budging by much even as the economy picks up steam.

A further problem with turning a blind eye to inflation is that it is tough to gauge what the inflation level would be without the fall in commodity prices.  It is not as if consumers have money to spurge having been stuck with stagnating wages and considerable debts from the pre-financial crisis spend-up.  Sluggish prices are harder to dismiss considering that low inflation is also caused by weak domestic demand.  With inflation likely to continue to play up for a while yet, central banks will need to be patient and bide their time before raising interest rates or else it will be the central banks that may be the ones getting into trouble.

Bargain Low Interest Rates to Continue in 2015

Borrowing is likely to stay cheap in 2015 as a drop in inflation puts pay to talk of higher interest rates

Christmas is usually followed by a rush off to the sales but borrowers need not hurry as cut-price loans are likely to remain for most, if not all, of 2015.  Acting like retailers with surplus stock to sell after Christmas, central banks slashed interest rates after the global financial crisis.  Six years later, there are growing calls for this to be reversed in countries such as the US and the UK due to as a strengthening economic recovery backed by more people finding jobs.  Yet, plans for higher interest rates have been way laid with falling inflation suggesting that all is not well with the economy.  With unemployment and inflation likely to fall further in 2015, there seems to be few reasons for any changes to be made to interest rates over the next 12 months.

Shopping around

The Federal Reserve and the Bank of England are in the midst of a dilemma – like a shopper not sure of where to head first to snap up some bargains after Christmas.  Unemployment data suggests that the economic recovery is becoming more entrenched with the proportion of Americans and Brits without jobs now below 6%.  Yet, despite more workers being hired, companies are still holding back from investing to expand output.  Aggregate demand is also suffering due to cuts to government spending resulting in an economic recovery that is still patchy.

If the stuttering economy is giving central banks reason to worry, it is inflation that is the real sticking point getting in the way of higher interest rates.  The extent at which prices are rising (or falling) has been adopted by central banks as a gauge for the health of the economy.  It is thus a point of frustration that inflation is heading downward as other signs, such as lower unemployment, suggest that the economy is picking up.  These mixed signals from the economy mean that Federal Reserve and the Bank of England are caught in two minds in terms of what do to with interest rates.

Best to stay put

Things are not likely to get any easier for central banks considering that the trends in unemployment and inflation are not likely to change any time soon.  With companies not yet willing to spend big on new equipment, it makes sense to employ more workers (who are relatively cheap) to get things done.  Lower commodity prices is the main cause behind falling inflation and a rebound in commodity markets is not likely as shifts in demand and supply of commodities taking years to change.  Neither are consumers in any mood for higher prices considering that wages have not kept up with inflation over the past few years. 

All this suggests that 2015 will be more of the same and interest rates are also unlikely to change.  Some will argue that interest rates need to rise to give central banks leeway to act in case of other threats to the economy.  Others will claim that the economic recovery means that inflation will be just around the corner and central banks need to pre-empt any jumps in prices.  But these are risky strategies considering that a bit of inflation in the future will do less damage to the economy than a premature hike in interest rates. 

A still fragile recovery means that, like any shopper out after Christmas, the economy could also do with a bargain (in the form of low interest rates).

Commodity Prices – Swings and Roundabouts

Commodity markets had gone off in their own direction but are now back on track to help out with the global economy

The global economy has suffered more downs than ups over the past few years but lower commodity prices will provide some long needed cheer.  Long after the onset of the global financial crisis, prices for everything from copper to vegetable oil continued to rise stoked by demand from places such as China.  Weaken global demand has finally taken affect and relief in on the way for consumers everywhere.  It is likely to provide a bigger boost than just a bit of extra cash.

A guide to the road ahead

Commodity markets often follow their own roadmap.  Demand for different materials can rise and fall depending on changes in technology or consumption patterns.  The rising wealth of China and India has pushed up prices for everything from gold to milk powder.  New fracking technology has lowered the price of oil while corn became more expensive due to its use in producing ethanol in the United States. 

Supply further complicates matters as rising demand for any commodity will prompt companies to increase output but this often takes time.  There is a lag of a year or so for farmers to shift from growing one crop to another and even longer for a new mine or source of oil to be developed.  The changing demand and the delayed response on the supply side means that twists and turns in the commodity markets are often accentuated.

Back on the map

Prices in the commodity markets had long been out of kilter with the slump in global demand but this seems to be over.  The price of oil, which has been making news recently, is indicative of this new trend.  Increased output in the US coupled with a tailing off of demand from energy-hungry China has resulted in a sharp turnaround in prices.  High prices for commodities such as oil often do not last as more money gets spend on both finding more oil as well as on increasing energy efficiency to lower money spent on oil.  Both of these factors act to stop the price of oil getting out of hand. 

Market correcting forces move in both directions and also work to prevent excessive falls in prices.  Investments in producing commodities are put on hold if prices drop back and low supply tempers a decline in prices.  Lower prices also mean that interest in using resource more efficiently tends to fade.  This is why commodity prices tend to fluctuate in big swings of boom and bust.  With the world economy have just endured a period of high prices, the commodity market seems to be swinging in the opposite direction.  Considering the big swings in commodity prices, this trend is not likely to be reversed any time soon. 

Heading in the right direction

The benefits of lower commodity prices extend beyond the obvious effects of cheaper prices at the petrol pump, on our gas and power bills, and when stocking up at the supermarket.  Less money will go to places such as Saudi Arabia and Russia, where high oil prices only add to the riches of already wealthy individuals, and consumers across the globe will instead have more money in their pockets.  As such, the global economy will benefit as this extra cash will likely to spent rather than piling up in the bank accounts of rich Saudis or Russians.

A further benefit of lower commodity prices is that cheaper commodities mean lower inflation and lower inflation allows more scope for looser monetary policy.  An uptick in inflation would be one excuse that central banks would use to raise interest rates.  But with inflation likely to be subdued (and deflation becoming more of a concern), interest rates are more likely to stay at their current low levels or hardly rise at all when interest rates are eventually raised.  The absence of inflation could even result in a long-needed rethink of what central banks should be doing in terms of monetary policy.  That may work out to be even be more valuable than a few extra notes in your pocket.