Economics of the oil price – so what?

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Petrol Price – why you need to understand it

Unless you’re in the financial services industry understanding basic economics is either as boring as hell or irrelevant. What control do you have over it anyway? Most of the time this exactly so, information overload is as dangerous as being clueless (it can lead to overconfidence and poor decisions). Occasionally though there are macroeconomic changes that you need to understand the basics of so that you can make better investment and long term decisions. While we might be a commodity and resource producing nation here in the good old RSA, one resource we don’t have in any meaningful quantity is oil and gas. It all has to be imported.

Problem 1 – for us in RSA – oil/petrol etc has to be imported in dollars. That has 2 implications. Firstly on our balance of payments – the equivalent of government’s credit card. Here’s a shocker – we are in debt, rather badly. To add insult to injury that isn’t good debt but has been spent on the equivalent of the groceries. Secondly our plummeting rand depreciation makes every barrel of oil we import more expensive.

Problem 2: Oil/petrol/diesel/gas is used in every industry, every home, every vehicle in the country. The price of oil impacts the ‘cost of doing business’ right across the board. Taxi rides or commutes for workers. Cost of delivering food. Cost of processing food. Cost of running stores, businesses, government departments. Keeping the lights on, pumping water. This impacts on inflation.

Problem 3: Inflation hurts our investments and puts pressure on the Reserve Bank to increase our interest rates. Higher interest rates hits the disposable income of middle class South Africans – the engine of the 60% of our GDP that comes from consumer expenditure. It also results in a rise in credit defaults, hurting business. In the past inflation was a result of excessive demand (by us, the consumer) – spend, spend, spend. This usually happened at the top of an economic recovery. Raising interest rates ‘cooled’ the economy.

Problem 4: Recovery? What recovery? What happens when you increase interest rates when you aren’t at the top of a recovery, but just shy of a recession? It ‘cools’ the already chilly economy to freezing point. That is the not-so-pretty picture we are looking at right now. Just before Nenegate the SARB (Reserve Bank) tried a little experiment – they thought they could ‘frontrun’ the American FED by increasing our rates before they did and so prevent Rand depreciation. Did it work? Resoundingly – for 48 hours.
There is absolutely no doubt about it, if the oil price wasn’t at 11 year lows in dollar terms we would be in a whole pile of pain and well into a recession. Will it last? The only way to answer that is to look at the dynamics of the international oil price and producers.

About a year ago OPEC decided to put shale producers out of business – the oil from this newish technology was pouring oil onto the market and threatening the traditional producers. They did this by increasing their production and forcing the price down. This tactic has  backfired. A year later and while many inefficient shale producers have gone under, it is hurting OPEC and other oil producers just as badly. Saudi Arabia (the driving force behind OPEC) is now dealing with a significant budget deficit (20%) for the first time in recent history and is cutting back on subsidies and capital expenditure where just a few years ago they were swimming in money and buying foreign land and businesses all over the world. One fall-out in OPEC countries is the disproportionate number of ‘foreign’ workers – at every level – doing the grunt and dirty work their populace didn’t want to do – resulting in a poor work ethic. Those workers can be sent home, but none of the locals want to do the work. The All-share index in Saudi closed 16% lower this year (even we didn’t do that badly).

How are the shale producers coping? They are getting rid of the warm bodies, focussing on the ‘gushers’ and using technology increase productivity. Sound familiar? All resource producers worldwide are doing the same, hence the massive retrenchments in some of our formerly blue-chip companies (Anglo, Glencore). It was economical to pump oil from shale at $50 a barrel, as it approaches $30 you are going to start seeing a rapid cut down in production, but that also applies to traditional methods with smaller producers – like Nigeria and Angola being hit the hardest.

It’s an international game of chicken, who is going to blink first – OPEC or USA? In the interim consumers should be making the most of it, like all things it will ‘revert to the mean (average)’ over time. Here in RSA we can only hope that when prices start increasing again we have our economy and exchange rate under control.

What is shale? This is the relatively impervious rock which ‘stores’ the oil which leaches out into the sand below, where oil can be easily extracted. Using traditional methods to try and extract oil in the shale layer almost immediately runs dry. They got round this problem by drilling horizontally into the shale and blasting millions of fissures into it often pumping in water under pressure, into which the oil could leach, and allow for extraction. The innovation and technology around this extraction method has exploded in the last few years. Producers have massively increased the productivity, cost effectiveness and dramatically reduced human intervention of this process. This sudden ‘new’ source of oil was hugely disruptive to the market – and added to the oil that continued to be produced by traditional producers at the same high level – a glut ensued. Pure supply and demand – oversupply brought the prices right down to where we see them today. In the West, governments and oil producers are making the most of the gut to massively increase the storage of oil meaning that even if prices rise, there is a huge glut that will takes months to work through the system. Thereafter we are still going to be in a new normal for the price of oil, despite the fact it is a finite resource. OPEC anticipate subdued prices for at least the next 5 years. The traditional oil producers are addicted to the massive income to their economies, so they are not going to cut back when they are already getting 1/3 of what they became used to – a catch 22 situation.

Unfortunately Fraking is not at all environmentally friendly, and there is growing evidence that it also destabilises the ground, leading to earthquakes and water table contamination. It also takes the pressure off looking for alternative energy sources. The sad reality though is that the world is still addicted to fossil fuel and traditional and Fraking producers are only too happy to fuel that addiction and they aren’t going to cut back and upset their economies back home.

Action: Get to grips with your personal ‘Disposable Income’. Are there areas, like the petrol price, that can change quickly and you have no control over? What will happen if the interest rate increases by 1,2,3%? Never mind the bond, what about other more expensive credit – loans, credit cards etc? The best remedy for uncertainty is the boring old ‘emergency fund’ – and no debt beyond the bond and car.

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Author Dawn Ridler ©

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