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Falling Oil Prices: What’s the Real Game?

Posted in Finance Articles, Total Reads: 1652 , Published on May 01, 2015

Last six months have seen a drastic fall in oil prices from $115 to less than $ 50 now. Is it a boon or a devil in disguise? At first, the answer appears simple; cheaper oil obviously is very good for global economy and especially for energy intensive country like India. Oil price fall not only will significantly improve country’s trade balance, considering that 80% of India’s imports are of crude oil, but also lower fuel prices would offer big relief from inflation providing final consumers with surplus money which they are free to spend or save elsewhere.

However, when looked more closely, the situation appears more complex with many factors requiring further attention and analysis. Consider this. BSE Sensex fell by 3% on single day on Jan 6, 2015 when crude oil price pierced the $ 50 a barrel mark. What could possibly explain such conflicting behavior of market? The answer lies in the market perception about the probable reasons for such free fall of oil prices. Prominent reason has been the weakening global demand; China has seen a growth slowdown, Euro is in debt crisis. The falling price is presumed as an indication of global economic slowdown or at worse recession. Of course, there are other issues contributing the market sentiment like fears over Greece exiting Euro Zone, China’s growth slowdown or Japan’s recession; but its prominence in driving the market segment can’t still be ignored.

Still, amidst these market fears, the benefits at the macroeconomic level to the Indian and world economy of these falling oil prices can’t be ignored. According a recent IMF report, a $ 10 per barrel fall in oil price will add 0.2 % to global GDP. Thus, the analogy of falling oil prices and global slowdown in long run appears unrealistic.

In order to judge such oil price fall’s sustainability require a deeper understanding of the causes of this fast sliding oil prices. Organization of Petroleum Exporting Countries (OPEC), a cartel lead by Saudi Arabia, controlling 40% of global oil output remains determined in maintaining its position of not cutting output to generate the required supply side effect in arresting this oil price fall due to falling demand.

OPEC members in their direct competition with US Shale Oil producers are playing an extremely risky game. Cutting the production is presumed as reduction of revenue and market share which they at any cost don’t want. Also, it is widely believed that at prices below $ 50 a barrel mark would make the shale oil gas production unviable helping OPEC maintain and even enhance their market dominance.

Apart from this demand supply mismatch, other factor widely believed causing this price fall is the market expectation of US Fed Reserve raising the interest rate. Considering that US economy has shown signs of improvement and that Fed Reserve has itself given an indication, the market is presuming the sooner than expected rate increase. The speculation of rate increase has caused a severe reverse carry trade of dollar with funds flowing back to US. Quantitative easing of US fed reserve has already ended. This quantitative easing (offering cheap dollar) and near zero interest rate offered extreme liquidity and thus massive funds flowed in commodity market driving their prices upwards. Now with this reverse carry trade of $, the funds have flown out of commodities causing their prices to fall.

As per majority, the oil prices are expected to remain low at least for current year. These low prices are definitely good for the final consumer in form of low prices and also for government in controlling inflation which is a direct indicator of bad governance.

At this time, a lot depends on how government exploits the current scenario. Government has two ways of achieving economic advantages through this falling oil prices. One is to compensate this oil price fall with increase of tax, receipts of which ultimately would be going for government’s development efforts, or else to pass on this price fall benefit directly to final consumers.

At first, the government is recommended to take this opportunity in removing its subsidy especially on cooking gas and fertilizers. Also among the two options, the government is advised to pass on the benefit to final consumer in form of lower prices (rather than increasing taxes) to help in GDP growth through increased consumption with multiplier effect. Inflation would be controlled along with. This will help in making the government achieve what is any government’s ultimate goal and responsibility, “Growth without Inflation”.

This article has been authored by Aman Maggu from IMT Ghaziabad

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