Oil prices dropped sharply this week including a one-day decline of nearly 30%. This was not a one-off hit to oil prices. In fact, the price per barrel of oil on global exchanges has been declining since it peaked at over $75 in 2018. In fact, oil prices have fallen by half in the past 19 months. This has weighed on energy company stocks, countries that depend on oil revenue to fund government spending, and the global financial markets. So, we ask the question: Why have oil prices declined and what does this mean for the broader financial markets?
As with any commodity that is a crucial input for global economies, the economic impact of oil prices is complicated. First, oil prices are often used as a gauge for the health of the global economy. When oil prices decline it is often viewed as a sign that demand is falling which in the past has been an early sign that the rate of global economic growth is weakening. Often the price of key commodities is one of the first places that weak economic growth is reflected in prices. Therefore, a sharp decline in oil prices may be a sign that the global manufacturing recession, which started several months ago, may be spreading to other areas of the economy.
However, we must ask if this time is different. While oil prices have declined in response to the trade war between the US and China, the recent plunge in prices is likely more related to the Coronavirus and its negative impact on global supply chains. Therefore, oil prices may actually be a better indicator of the impact of the virus rather than the longer-term performance of the global economy. Should the impact of the virus be mitigated in the coming months, it is possible that oil prices will bounce back.
The supply picture is also important. The recent decline in oil prices came after the Organization of Petroleum Exporting Countries (OPEC) failed to reach an agreement to limit oil supplies. Therefore, the current agreement will expire at the end of March allowing oil exporting countries to pump and sell as much oil as they want. This could cause new supply to flood onto global markets pushing down prices. While this may be a bad result for oil companies it is not necessarily a reflection of weak economic growth. Instead it may be more a reflection of the pressure that increased US oil production has put on oil exporting countries making it difficult for them to cut production and still fund their spending plans.
A weaker OPEC and lower oil prices could have a positive impact on global economies. Lower oil prices reduce input and transportation costs for many businesses. These savings can improve company profit margins or be passed on to consumers. This could benefit industries that use oil as an input and allow consumers to direct the money that they are saving at the pump to spending in other areas.
It is also important to note that the decline in oil prices could be the culmination of a super cycle. Arguably, the super cycle in oil peaked in 2008 when oil prices reached $150 per barrel. The high oil prices were a result of low investment in oil infrastructure over the previous decade due to the low oil prices that persisted for most of the 1990s. When demand increased in the 2000s it exposed a supply capacity shortage which caused prices to surge. However, this surge in prices fueled a surge in investment which led to a sharp increase in global oil supply capacity. Today that capacity is being used to flood the market, pushing prices down in the process. Now we are once again in the low-investment phase of the cycle as the price of oil does not justify the cost of new projects. If history is an indication this phase could last a decade or more before oil demand increases to the point where supply capacity proves to be insufficient.