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Darren Winters is a self made investment multi-millionaire and successful entrepreneur. Amongst
his many businesses he owns the number 1 investment training company in the UK and Europe.
This company provides training courses in stock market, forex and property investing and since
the year 2000 has successfully trained over 250,000 people.

Monday, 5 January 2015

Oil Deflation - Two Sides to A Coin

The recent collapse in the price of oil has been dramatic. In the last six months the price of a barrel of crude oil has lost almost 50 percent of its value. Most recently, in one week alone, oil shed a further nine percent of its value. Oil traders would have to go back fifteen years to see the spectacular movements in oil prices that we are witnessing today.

In a previous piece on oil I examined the probable factors causing its price to tumble, but I will now focus on the impact collapsing oil prices are likely to have on economies, governments and companies.

For some economies, collapsing oil prices can be a mixed fortune.

What we are seeing is a transfer of wealth from oil rich countries with relatively high savings and low consumption to nations with low savings and higher consumption.

A manufacturing based economy with relatively little or no natural resources that is heavily reliant on oil clearly benefits from cheaper oil. Cheaper input costs, such as oil, for a given output means lower marginal costs, higher productivity, more profits and a boost to consumption. So the net impact of cheap oil for the US, the EU and Japan is likely to be positive, in terms of consumption and economic growth. These are consumer driven, manufacturing economies.

At current oil prices, households are likely to save 400 USD a year due to cheaper gasoline at the pumps, lower electricity costs etc. If there is no price inflation in non-discretionary expenditure (essential expenses that a household needs to make such as, food, water, electricity, council taxes etc.), the consumer will have more change in their pocket to either save or do a little bit of discretionary spending on travel, movies, restaurants and consumer electronics. In a healthy economy, discretionary expenditure (spending on non-essential items (luxuries)) is high.

So then, is the net impact of collapsing oil prices is likely to be positive for EU, US and Japan?

That depends. For example, if there is price inflation in non-discretionary spending, then any savings from cheaper oil is likely to be gobbled up, leaving nothing in the kitty for discretionary spending. In this case, the collapsing oil price might be a zero sum game.

There is also another reason to be cautiously optimistic about oil deflation.

Parts of the economy in the energy sector are likely to be feeling great pain from collapsing oil prices . For example, the oil giants, downgrading profit forecasts, reducing investments and cutting jobs in an attempt to reduce costs and keep their profits from plunging.

“Oil giant BP is accelerating plans to cut hundreds of jobs within its back-office departments - many of them based in the UK and US,” reports an article in the BBC entitled, “BP quickens job cuts due to oil price fall,” dated December 7.

"The fall in oil prices has added to the importance of making the organisation more efficient," a BP spokesman told the BBC, "and the right size for the smaller portfolio we now have".

The move is also being echoed by another oil giant

Haliburton, the world's second-biggest oil services company, recently announced to the media mass layoffs in Europe, Asia, Africa, the Middle East, as well as in Australia. “We are right now anticipating a restructuring charge in the quarter, probably to the tune of about $US75 million ($81.15 million), as we trim out some headcount and activities around the world," chief financial officer Mark McCollum told investors.

Indeed, it is the downsizing of business activities, which also corresponds to a fall in investment that could be up-to one trillion USD of capex expenditure frozen-up, according to a recent article in the FT. So declining business investments cannot bode well for the economy going forward.

But it is the economies heavily reliant on oil for revenue that are really being whacked by oil deflation. So concerned about the recent oil price collapse that the International Energy Agency (IEA) warned “plunging oil prices might trigger civil unrest,” according to a recent report issued a few weeks ago.

IEA is forecast that the glut of oil will continue throughout 2015 and that is likely to dampen future oil prices.

The big oil producing nations heavily reliant on oil for income have a good reason to be worried.

Russia depends on forty percent of its revenue from energy exports. It is no surprise then that oil deflation has wreaked havoc on the rouble, which is now worth 50 percent less than the USD dollar in just one year. Russia's central bank has spent billions of US dollars of their foreign reserves, selling dollars and euros buying the rouble with the aim of propping it up, but it has been to no avail. Russia's central bank raised interest rates to 17 percent as the rouble continues to plunge.

The aim is to try and hold back the tide of capital outflows and attract capital inflows. It may periodically shoot up but if the trend is against the rouble and sometimes even central banks can't win.

The collapsing oil price is also eating away at Nigeria's foreign reserves.

Nigeria's naira spiked higher after central bank intervention. The Nigerian Monetary authorities have been struggling to keep the naira trading within its new band of 160-176.

So as hot money flows into monetary regions of higher exchange rates this might cause another problem i.e. a liquidity crisis. Other central banks around the world might then be forced to raise rates in an attempt to stem capital outflows from their monetary region. If that were to happen, higher rates would not only send bond prices crashing and yields soaring, it might also choke off investment.

A collapsing oil price also means collapsing petrodollars that get recycled through the western banking system and channelled into stock markets and infrastructure investments. With that money tap now tightened, companies on the receiving end of it will feel the liquidity pinch.

Other big losers will be alternative energy, the Shale boom might turn to Shale bust. Solar power and wind turbine energies are all in the firing line.

Then there is the issue of a credit default if the economies in oil dependent countries deteriorate to such an extent that they can no longer service their sovereign debt.

Not to mention the astronomical loss that someone must be nursing on the derivatives market, due to bad bets on oil prices, which is probably big enough to bring down a bank...more liquidity problems downstream.

There are two sides to a coin.


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