The drop in oil price and its effect on the economy

Those with long memories will vividly recall how the Arab-Israeli war of 1973 and the Iranian revolution in 1979 sent the oil price sky-rocketing. OPEC was then a powerful cartel, and when it decided to flex its collective muscle the world, especially the developed world, took notice.

Zaki Yamani, Saudi Arabia’s western-educated, oil and mineral resources ,inister from 1962 to 1986, became a regular fixture in the Western media, his every utterance about the oil price pored over by analysts, media and governments alike.

It set a pattern – Middle East unrest equalled higher oil prices, as importing countries on the OPEC oil drip moved swiftly to shore up their reserves in troubled times.

On this historical basis, the price of oil should be at an all-time high. Today we have an ongoing crisis in Syria, with the latest complication being Russian intervention, Islamic State still sowing seeds of destruction in Iraq and Syria, rising tension between Saudi Arabia (Sunni) and Iraq (Shiite), and the intractable Israeli-Palestinian conflict. And this doesn’t include the issues in Yemen, Libya and Nigeria. Yet the price of oil continues to fall.

In June 2014, a barrel of oil was trading around $US115 a barrel. Today it is trading around $US30 a barrel – nearly a 75 per cent drop in price.

The reasons are many and varied, but, to my mind, four stand out. OPEC lacks its clout of yesteryear. Other large producers such as the US and Russia have taken market share. Second, OPEC is bitterly divided, notably Saudi Arabia and Iran. Third, Saudi Arabia, OPEC’s largest producer, is determined to drive high-cost producers such as the US shale oil industry (which is mostly unprofitable under $US70 a barrel) out of the market as well as reducing revenue for Iran. It’s a long-term goal – and the Kingdom is prepared to pay the price of lower oil prices to achieve this goal. Fourth, China is a net importer and its economy is losing momentum.

So the geopolitical dynamics influencing the oil price have changed. But what’s even more interesting, I believe, is how the market reaction to the oil price has changed. The 1973 oil shock sent shock waves through share markets, ushered in higher inflation and triggered an economic slowdown. It signalled a sharp end to the unparalleled growth of the 1950s and 1960s. The 1979 Iranian revolution had similar consequences.

On this basis, it’s reasonable to speculate that a 75 per cent drop in oil price would have investors thinking positively. But not so, as we have patently seen with the Australian share market this year. It not just Australia; the S&P500 and FTSE100 have also come under pressure due to their heavy weighting to oil stocks. Some oil companies in the US will fold, notably in share oil production. What’s keeping many afloat now are forward contracts at high prices; once they expire so will the companies – literally.

Conversely, those countries that don’t have a heavy weighting to oil producers in their indices should lead to better share market performance. Most European indices are an obvious example.

Finally, oil around US$30 a barrel is not sustainable. The world’s economy is still geared to “black gold”. In this sense the worst enemy of lower oil prices is lower oil prices. As the oil price falls so will demand grow, which will eventually work through the oversupply as new oil projects don’t come on-line and non-profitable producers exit the market.

In this sense, the Saudis have it right. Prices at this level, will, over time, fundamentally reshape the oil industry, and the low-cost producers will be the beneficiaries. But once they have production under control, and supply and demand back in some sort of equilibrium, they will begin to push the price up again. Let’s just hope when they do the market takes it as a positive sign. But I wouldn’t stake an oil well on it.

George Lucas is managing director of Instreet Investment Limited. He has more than 24 years' experience in the investment banking and funds management industries specialising in developing, managing and structuring financial products. He was previously a director of two listed investment trusts, chief investment officer at Mariner Financial, and a senior equities derivatives trader with Citibank and First Chicago in London.