Cheap oil: More fuel than foul for the economic engine

Russell’s Senior Investment Strategist Wouter Sturkenboom recently wrote a blog post highlighting the team’s thoughts on the possible wins and losses that cheap oil may create for the global economy. You can read the full post below or on the Russell Blog Since mid-2014, watching the price of Brent crude has been like watching a falling rock. From USD $115 a barrel in June, to $80, then $60, then to just above $50 as of January 8, 2015. A dramatic plunge. For the most part, this is very good news for the global economy. But there are a few caveats – a swing this sharp and rapid can be unsettling, to say the least. First, why the big drop? Part of it comes from the fact that economic growth in Europe is slow to non-existent, and slowing in Japan and China. In our view, about one-third of the price drop is due to this slackening demand. For the rest we can most likely thank high production. New technologies to extract oil from shale in the United States and Russia have left those countries awash in the black stuff. Meanwhile, big producers such as Saudi Arabia are not cutting back for fear of losing market share. The result is a huge transfer of wealth from oil producers to oil consumers. Now, dollars that would have gone into sovereign wealth funds in the Middle East or Norway will likely go to consumers in the United States, Japan, and Europe. That’s important, because as Bloomberg BusinessWeek pointed out recently, consumer spending accounts for close to 70% of the U.S. economy. So consumers there and elsewhere will likely see wads of dollars, euros, or yen put into their pockets. Automakers, airlines, big fleet operators such as FedEx® – all may benefit as well. Here at Russell, we’re even discounting low-cost oil’s contribution to recent deflationary numbers out of Europe simply because lower energy costs constitute the kind of deflation economies like. If there’s a darker side to this, it’s the sheer rapidity of oil’s descent. In our experience, there are entities around the world that are likely under enormous pressure from oil’s drop, either because they hold debt they hoped to pay off with oil dollars, or because they have derivative positions. For the most part, no one knows yet who’s really exposed – “ swimming naked,” as Warren Buffett likes to say – and the impact when their exposure is revealing. Such a situation can create uncertainty in markets, and markets hate uncertainty. The swings in U.S. stocks over the past few weeks can be explained in part by this lack of transparency into cheap oil’s casualties. Cheap oil also has geopolitical consequences on oil producing countries. Expensive oil made Vladimir Putin arrogant. Cheap oil likely is making him frightened, which could be even worse. Who knows what mischief could be caused by a Russia with little to lose? Cheap oil also puts enormous strain on Venezuela, and could further destabilize an already fragile Middle East. Nonetheless, go ahead and raise a toast to cheap oil. But don’t overdo it – this respite won’t last forever, and may yet cause a few difficulties we can’t foresee.