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Oil prices: what’s behind the drop?

Date: Feb 10th, 2015

There’s been a lot of commentary around the recent drop in oil prices, and what it might take for them to recove r. Integral to this discussion is the Organisation of Petroleum Exporting Countries (OPEC) and Saudi Arabia, which produce about 33% and 9% of the world’s oil respectively. In this article, we examine the factors that have led to the drop in prices and what this all means for investors.

Some background

Last year, at a meeting in Vienna on November 27, the OPEC voted to maintain oil production at current levels. As a result, we’ve seen the price of oil plummet by more than 50%, from a high of over US$100 a barrel for brent crude oil last year to below US$50 a barrel in recent times. The hardest hit have been oil-exporting countries such as Russia, Iran, Nigeria, Venezuela, Norway, Canada and Mexico.

A case of supply and demand

The sharp drop in prices has been caused by a supply glut. Continued growth in US shale production and an increase in non-US OPEC oil exports have led to excess capacity. This is being exacerbated by slowing demand which is a product of slowing growth in the emerging world. Also, some nations, such as Japan, have substituted oil for natural gas and alternative fuel sources. A stronger US dollar hasn’t helped either. This weighs on most commodity prices as they are priced in US dollars.

Conspiracy theories emerge

Some believe that the US and Saudi Arabia have colluded to lower oil prices as a way of punishing Iran and affecting the economies of Russia and Venezuela. There’s also been commentary that the Saudis may view long-term low oil prices as a way of combating their geopolitical rivals and hindering Iran's nuclear program. Other conspiracy theories revolve around the fact that if oil prices decrease far enough and remain low for long enough, Saudi Arabia may steal market share from US shale producers and thus gain far more long-term revenue. This may also serve to weaken its major rivals in the Middle East (both in an economic and military sense) and expand its sphere of influence.

Many of the conspiracies have similar structures — suggesting that there are deeply powerful but unseen players working behind the scenes to shape world events. These are certainly much more colourful than a story about supply and demand which may be more technically accurate.

What does this mean for investors?

Share markets have reacted negatively to the fall in oil prices in recent weeks. This is because the negative impact on energy producers is what is most visible and this is being magnified by the steepness of the fall. Interestingly, over a longer period of time, lower oil prices will likely have a positive impact on global growth. In fact, after oil prices plunged in 1986, 1998 and 2008, US shares gained an average 23% over the subsequent 12 months. In effect, any significant downturn in share markets in response to lower oil prices should be seen as a buying opportunity. As benefits from lower oil prices start to flow into the economy, this should help drive share markets higher by year-end.


About the Author
Nader Naeimi, Head of Dynamic Asset Allocation and Portfolio Manager, AMP Capital


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