There is a popular belief among global investors that crude oil prices need to be in equilibrium. Very high prices are not a good sign because they impact the cost of downstream refined products and also add fuel to inflation. Secondly, this leads to a huge wealth shift to the oil producers like the Middle East and Latin America from the oil consumers like India, China, Japan and Europe. High oil prices also tend to impact the demand for oil and that elasticity is seen prominently at higher levels. What happens when oil prices crack sharply?
It leads to a wealth shift from oil producers to the oil consumers. We saw that since 2014 when Saudi Arabia depleted its reserves sharply and Russia came under pressure when the weak oil prices combined with sanctions imposed by the US. Secondly, most of the oil companies the world over have significant weights in the stock market indices. Hence weak oil prices takes away a significant amount of wealth from the bourses. This was seen in the period post 2015.
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How are oil prices and the global economy correlated?
Oil is globally a multi trillion dollar industry. Also it is an important input for transportation, home heating, industries etc. Hence the significance of oil goes much beyond just the price and affordability. It gets into the cost push inflation of any economy in a big way. Let us look at some key factors impacting the correlation between oil prices and the global economy.
- More often than not, high oil prices have been a side effect of high levels of growth. We saw that trend between 2006 and 2008 when Brent crude actually got to a high of $140/bbl. This was purely driven by growth and growth expectations. While reasonable levels of oil prices are essential, oil above $100 has never been a comfortable scenario. In fact, when oil prices go up sharply, they have an impact on inflation. This compels central banks to hike rates and other central banks follow suit. Suddenly, the benchmark rates are higher and that is impacting equity markets as the cost of funds has gone up. That was one of the reasons that led to oil crashing from $140/bbl to $70/bbl in the post crisis scenario in 2008.
- Very low oil prices are also not a great sign as it can push a lot of economies to the verge of bankruptcy. This is true of countries that predominantly rely on oil as a source of national income. Back in 1998 when oil fell to $10/bbl after the Asian crisis, Russia was pushed to the brink of default. In fact, the rouble actually defaulted. Post 2014, we saw Saudi Arabia depleting its forex reserves by nearly $250 billion and also cutting most of its relief programs due to weak oil prices. These are not very comfortable scenarios. More recently, Venezuela (another economy that depends heavily on oil) has also been pushed to the verge of hyper inflation and bankruptcy due to weak oil prices. These are all the outcome of weak oil prices.
- How does the price of oil impact the economy of a country like India. India finds itself in a difficult situation because it imports nearly 85% of its daily oil needs. That means a sharp rise in oil prices globally not only increases the domestic price of petrol and diesel, but also expands the trade deficit and the current account deficit. These have a direct bearing on the rupee value and we have seen the rupee depreciate sharply between October and December 2018 on the back of higher crude prices. This also has a side effect in the form of FII selling.
- Oil prices have a very important implication for the growth of alternate energy. One of the main intent of alternate energy is to reduce the dependence on fossil fuels like oil and coal. But investments in alternate fuels have a weird cycle that it follows. When the price of crude is high, producers are making hay and there is no incentive for existing players to shift to alternate fuel production. When the price becomes too low, consumers are benefiting and hence alternate energy companies find it hard to justify their investments.
Oil prices are not just about inflation but the macro fortunes of many of the 25 largest nations are closely linked to the price of oil. That is the key!
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