The Falling Oil Price – mirror on China, geopolitical football or beacon of hope?

The oil price has fallen from $128 on March 1 to below $90 in recent days, but this sharp decline has received little news coverage.  There are good reasons from both supply and demand perspectives why this 30% fall has occurred:

On the demand side

  • Economic data since March have disappointed expectations, following a burst of optimism in January and February on the back of the ECB’s dramatic action to offer a trillion Euros of extra 3-year liquidity at the start of the year. However none of this liquidity made it into the real Eurozone economy – it went into the banking system and the banks used it to support the government bond markets in Spain and Italy as many other investors used the opportunity to exit from their Euro assets.
  • Austerity continues to drive the peripheral countries deeper into recession and the German economy has seen its export engine struggle as the rest of the world slows down.
  • In the US, the improvement in the labour markets that appeared to be taking place at the start of the year has stalled as austerity from the individual states, which are forced to run balanced budgets, has reduced domestic demand. Growth expectations for 2012 have been steadily reduced over the course of this year.
  • It is however the Chinese economy which is the key driver of oil demand, and although not clearly reflected in the official statistics, which are aggregated from local regions all keen to show themselves in a good light to the centre, there is increasing anecdotal evidence of a major slowdown in demand from manufacturing companies for raw materials with the appearance of large inventories of coal and copper within China, together with continued weakness in demand for electricity.

On the supply side:

  • Saudi Arabia has pumping record amounts of oil over the last three months and shown no sign of reducing this rate of production as the oil price has fallen  close to levels (generally assumed to be $80-90 per barrel), which make it difficult for them to balance their budget. They have declared this to be part of a policy aimed at helping the Western economies – closer to the truth might be that the American authorities have requested a much lower oil price, which would boost consumer disposable income and confidence and thus give more room for the Federal Reserve to ease policy and for Obama to win the election in November.
  • Oil production and exports from both Iraq and Libya have been expanding rapidly this year as calm has returned to these countries and with it a focus on rebuilding export earnings.

So weaker demand and increased supply have occurred together and prices have fallen sharply. For Western economies trying to deal with the after–effects of a major banking crisis, this is positive news.  Lower petrol prices leaves more money in consumer pockets to spend in other areas of the economy, at a time when consumer incomes are otherwise under pressure, and allows the Central Banks to be more relaxed about any inflationary pressures. Should Europe be able to find a way through its problems in the next few weeks, there may be scope for an equity market rally.

In the longer term, it should be noted that the USA is moving aggressively towards being energy self-sufficient). The new fracking technologies are significantly increasing the productive potential of its own gas reserves, which will, over the long term, ensure that it will not be dependent upon the Middle East for its energy requirements. Structurally this bodes well for the US relative to Europe and Japan, which will remain more beholden to political developments in those regions, and therefore for the dollar relative to the euro and the yen.