When markets opened on Monday, the price of crude oil fell by the largest amount in a single day since 1991. The sudden price drop came on top of investors’ concerns about the coronavirus, resulting in a bad day for stock markets, with negative performance for many portfolios. In this blog we try to explain what’s happened between Russia and Saudi Arabia to prompt the sudden fall in the oil price.
Why has the oil price declined so much?
Even before this weekend’s events, concerns about the outlook for the global economy were weighing on global oil prices. The epicentre of the Covid-19 outbreak thus far, China, is one of the largest consumers of oil. It’s also the largest importer of oil and, importantly, a key source of new oil demand.
Prior to the outbreak of Covid-19, forecasters expected Chinese oil demand to rise given the completion of a “phase one” trade deal with the US and brighter prospects for global trade. But the strict travel restrictions put in place in China to contain Covid-19, and the resulting fall in economic activity, has temporarily reduced demand. This trend has accelerated as Covid-19 spread outside of China. Falling global demand caused a drop in the oil price by 13% in February, according to Bloomberg.
In response to declining prices, the oil producing nations, led by Saudi Arabia, began to discuss coordinated cuts to production that could potentially push prices up again. However, talks collapsed on Friday after Russia refused to agree to a supply cut, instead favouring a strategy that it believed would help it retain its market share.
In retaliation, Saudi Arabia during the weekend decided to increase production and started offering its oil at a steep discount – cutting the relative price at which it sells its crude by the most in at least 20 years1
The good and bad of falling oil prices
From a macroeconomic perspective, falling oil prices are good news for users of oil – countries that import it and consumers. But a low price is bad news for those nations that export it and for companies involved in the production of oil.
Many oil exporting nations rely on oil revenues to fund government spending. Sustained low prices may force these countries to raise taxes or cut spending, particularly if they face a budget deficit.
Similarly, many companies involved in the production of oil have seen the price of their primary product, and therefore their expected profit margins, fall significantly overnight. Companies in the energy sector account for around 4.2% of the world’s stock markets2, and a medium term outlook for lower oil demand is damaging to this sector’s share prices. The same is true in the credit markets. Energy companies account for around 13% of the outstanding debt in the “high yield” bond market3. This is the corporate bond market for borrowers with lower credit quality. Falling prices make their borrowing less sustainable, and therefore the value of high yield bonds may decline as investors anticipate a greater risk of defaults.
On the other hand, when oil prices fall, business and household consumers typically enjoy lower costs. The effect can be compared to a tax cut that boosts spending power. Energy costs account for around 7-10% of the US consumer price inflation basket and between 6-10% in the UK. Lower prices feed through to lower inflation, which in turn will also help keep consumer borrowing costs low.
Cheap oil lowers the cost of trade for businesses, for example by making it cheaper to produce and transport goods. This is particularly important for industries where oil is a major input, such as airlines, consumer goods and even pharmaceuticals.
What this means for you – and what comes next?
Because oil is involved in so many industries, a dramatic change in the oil price has many knock-on effects. In fact, the sudden change in price and the uncertainty it creates is one reason we’ve seen stock markets fall in response to the news. On the other hand, a lower oil price may have many benefits for some consumers, industries and countries.
We discussed the effects of the oil price drop in a webcast with Q&A.
- Goldman Sachs, The Revenge of the New Oil Order, 08/03/2020.
- MSCI, figures correct at 28/02/2020.
- BofA Merrill Lynch, figures correct at 28/02/2020.
As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past performance and forecasts are not reliable indicators of future performance.