Inside investment: Oil – let it flow, let it flow
Markets ended 2014 beset by fear. Deflation is now a global concern and the doomsayers see rapidly falling commodity prices as the canary in the coalmine. But the nattering nabobs of negativism are wrong.
Oh the markets outside are frightful, but the dollar is so delightful, add oil for a rosy glow, let it flow, let it flow, let it flow.
Apologies to Sammy Cahn (lyricist) and Jule Styne (composer) for this shameless mangling of their seasonal classic Let it Snow.
Plagiarism is the sincerest form of flattery, and the sentiment is genuine. The 40% fall in the price of oil should be a reason for new-year cheer – it is an unalloyed good thing for the global economy in 2015.
The counter arguments are not very persuasive. There are individual companies, particularly those that are leveraged and in exploration, that will go bust if the price stays at these levels. Their business models will not work. Some countries, including Russia and Venezuela, will have difficulty paying their debts.
Defaulting companies are as inevitable as the business cycle. When sovereigns fail, the consequences are ugly, but the world soon moves on. Serial defaulters find that capital markets are open to them again if they pursue broadly sensible IMF-approved policies.
The case for the bears is based on an unknown. It suggests falling oil prices are a forward-looking indicator of declining global demand and a tipping point into deflation and recession. Broader commodity prices are a concern.
The S&P GSCI Commodity Index, which has a heavy weighting in energy, was down almost 30% year-to-mid December 2014.
Copper prices have also fallen by 12%. Rightly or wrongly, the price of this metal is often regarded as a barometer of the economic fortunes of China.
Markets have caught up with a fundamental change in energy markets. US oil production, due to the fracking of shale, is back up to 1970s levels, and so are reserves. Oil prices are at levels last seen in the aftermath of the global financial crisis in 2009. It is hard to stack up a case for why oil should go back north of $100 a barrel any time soon.
There is new supply in the US. Poland looks to be sitting on a shale gusher. The linear relationship between global growth and oil demand has also broken down as subsidized alternatives become more viable. That is bad news for oil producers and countries, though the smart ones have put counter-cyclical buffers in place, such as Norway and its Petroleum Fund.
When divining conclusions about the economic effects of oil, the impact on Norwegian consumers of the plunging krone (population 5.1 million) needs to be weighed against those of net oil importers such as India (population 1.2 billion) and China (population 1.3 billion).
The IMF thinks that the fall in oil price so far is likely to add 0.5% to global growth next year. That could be boosted to 1.2%, more than $1 trillion, if consumer confidence rises. Indian auto sales rose 10% in December. Consumer confidence in the US is at an eight-year high.
It is also probably unwise to read too much into other commodity prices. A Glencore executive recently told the Financial Times that Chinese demand for copper was “extremely strong”. Stocks in Shanghai, London and Chicago are at their lowest levels since 2008. Production at the world’s largest copper mine, Escondida in Chile’s Atacama Desert, are expected to decline this year.
The canary in Chile’s copper mines suggest it is hard to extrapolate a weak oil price with reduced economic activity and demand. Higher demand, lower stockpiles and lower production should mean a higher copper price unless a new economics textbook has been written and no one bothered to send it to me.
Like Norway with its oil fund, Chile has a stabilization fund designed to protect against any decline in copper prices. Chile will not go bust, and copper could well be headed higher.
Investors desperately searching for a new theme in 2015 might be disappointed. With central banks (including FX reserves) owning $22.6 trillion of the world economy, it will be business as usual. They are the only actors that matter on the global economic stage. The likes of Opec are barely bit players.
The central banks want reflation. As noted before, the strong US dollar is a safety valve that is helping by allowing the euro and yen to fall. But investors have already capitulated. Not only have they been selling Treasury Inflation Protected Securities all year, according to Bank of America Merrill Lynch, they are now selling floating-rate securities, presumably because they believe the outlook for inflation is so benign that interest rates will never rise.
William Safire, the former speechwriter to president Richard Nixon and New York Times columnist, followed his famous phrase about nattering nabobs by calling Nixon’s enemies the 4-H club – the hopeless, hysterical hypochondriacs of history. He was wrong. But those who believe a declining oil price presages generalized deflation are in a new 4-D club: delusional, dopey, depressive, deflationistas. Let it flow.