The oil price, geopolitics and growth

by George Hatjoullis

Brent Crude

The Brent crude price has been been falling steadily for some weeks. It has fallen by over 10%. It has done so despite many geopolitical tensions that might normally have been expected to send it higher. There are no obvious supply peculiarities that can cause a specific type of crude oil to deviate from the carbon fuel price spectrum. Other grades of crude and natural gas exhibit similar price dynamics. So what explains this price weakness?

The advent of fracking is beginning to change the supply situation of carbon fuels but there has been no specific surge in the last few weeks. Similarly the move to alternative non-carbon based fuels and technologies that economize such fuels is a steady process and did not accelerate in the last few weeks. Indeed the growing tension with Russia and in the middle east might reasonably have caused a firming of price. The latter makes the soft price even more remarkable. There is clearly a lot of supply relative to demand. If it is not supply then it must have something to do with demand.

This is not simply a spot price issue. Forward prices have also fallen proportionately. The implication is that, despite an uncertain supply situation, demand is seen as potentially very weak going forward. There has been continuing concern about growth in China but the implied weakness in the growth outlook may be global. Oil is after all a global commodity. Excess supply of oil in the present context implies excess supply of many commodities and goods.

The other supporting evidence for this implication is everywhere the lack of inflationary pressure. This lack is all the more surprising given the exceptionally easy money policies followed by all central banks in the last few years. As previous blogs have highlighted, the failure of easy money to ignite goods price inflation reflects broken banks and the lack of credit creation. The easy money has nevertheless helped through the wealth effect of the consequent asset price inflation. The potential for this wealth effect to sustain economic activity has now been reached and sustained economic growth needs a boost from other sources. The oil price would suggest that this boost may not be forthcoming. This has important implications for monetary policy.

Central banks (with the possible exception of the ECB) can do little more through established channels to boost economic activity. However, they can hurt it if their actions reverse the wealth effect that they have so painstakingly created. This explains the sudden popularity of CB transparency and forward guidance. Some central banks feel the need to ‘normalise’ interest rates but do not want to cause asset prices to crash in the process. They are thus at pains to explain why the rate increases will be slow and obvious and will terminate at a much lower historical level. This is fine but it will not generate growth and current valuations really need some healthy growth to sustain themselves let alone advance further. From where can this growth come?

Governments have, since Keynes, been the buyer-of-last-resort. However, owing to a recent aversion to government debt, governments are not able to expand their spending and are by and large contracting same. This does not augur well for future growth. Something needs to come along and boost aggregate demand globally. The only policy tool that could do this is anathema and on a par with devil-worship; monetary financing. However, this has been discussed at length in previous blogs. In the absence of monetary financing, or some other exogenous influence, the global economy looks set for slower growth and some economic regions (eurozone) will flirt with deflation.