When it comes to commodities there are few more important than oil. Therefore it should come as no surprise that the recent sharp decline in the oil price – it has slid more than 40% in the past six months — is having ramifications across the world, both positive and negative, and has precipitated an economic crisis in Russia.

The reason for the decline

The price of anything is determined by supply and demand. Too much demand and too little supply and prices rise. In contrast, too much supply and too little demand and prices will decline. The question therefore is whether the slide in the oil price has been driven by an increase in supply or a fall-off in demand. The latter would be a major worry because it could imply that the global recovery is already faltering.

Thankfully, the evidence for this is weak. We are continuing to see strong growth coming out of the US, which, as the world's largest economy, has the power to pull the entire global economy along in its slip stream. The US created another 321,000 jobs in November, well ahead of forecast, while a consumer sentiment index climbed to its highest since January 2007; this is not the sign of a recovery that is running out of fuel (and indeed the lower oil price may well accelerate growth).

Instead it seems that the culprit is in fact an increase in supply. Although it has been difficult to pinpoint who is responsible, there is talk that the US has been increasing the amount of shale gas it is extracting, which competes with oil in energy markets and therefore can lower the oil price if produced in abundance. There's also the strong suspicion that Saudi Arabia, which has oodles of reserves that it can extract at a lower cost than most oil exporting nations, has been pumping more liquid gold, or at least has been happy not to slow down production while a glut manifests itself elsewhere in energy markets. When we consider the winners and losers from the price decline, both of these scenarios seem very plausible.

The winners

The one major winner in this entire process is Saudi Arabia. As its marginal cost of extracting oil is very low, the country can happily continue with production at rock-bottom prices. The longer the price stays low, the more it will knock out other producers of energy – oil and shale gas – who have a higher marginal cost. The Saudis could at a time of their own choosing pull back on production, jacking up the price again because of the squeeze on supply, while maintaining market share having removed some of the competition (already BP has said it is shelving some oil development plans due to the low price.)

Another major winner is the US. Because it has a lower fuel tax rate than many other nations, a cut in the before-tax price of oil has a much more immediate and significant impact here than elsewhere. In fact, many economists reckon a drop in the oil price is the equivalent of a tax cut in terms of promoting economic growth.

The losers

It's uncanny that amongst the biggest losers from the falling oil price happen to be a group of nations considered hostile to US and Saudi interests.

Iran, a challenger to Saudi Arabia for regional hegemony in the Middle East, an ally of the Syrian government, and until recently enemy No. 1 for the US, has a much higher cost of extracting oil than the Saudis. To finance the country's spending commitments Iran needs an oil price of around $136 a barrel, according to the International Monetary Fund figures.

Another country to fall foul of the decline is Venezuela, a strident socialist outpost in the US's backyard that has been funded by its reserves of oil. The sharp decline means that the country may be on course to default on its debt, not something that would overly irk Washington.

However, the biggest loser in geopolitical terms from the price drop has to be Russia, which has financed its growth and more muscular foreign policy with the proceeds from selling oil. With its alleged incursions into Ukraine, annexation of the Crimea, suggestions of provocative military manoeuvers from the channel to the Nordic regions, and strong support for the al-Assad regime in Syria, it has managed to seriously upset both the US and the Saudis. Anything that would unsettle Russia, and in particular President Putin, is likely to be seen as good thing in senior circles in both of these countries. Already Russia is having to take drastic action to protect the rouble, which has lost nearly half its value this year against the dollar, pushing up interest rates to 17% in recent days. President Putin has warned that the economic crisis there, which has seen inflation rocket as the rouble tumbles, could last two years.

The investment conclusion

With both winners and losers around the world, we must assume that the outcome for investors from the decline in the oil price is balanced. The economic uplift in the US, which should extend throughout the world, is countered by the threat of a cornered, more aggressive Russia, and volatility in bond markets that any default would cause. It's also worth considering that there may be domestic US losers, with some shale gas producers suffering as the cost of production suddenly ends up above the price they get when selling their resource. Some of the more speculative shale gas ventures have been heavily debt financed and their collapse could cause some ripples in corporate debt markets.

The lack of a clear positive or negative outcome can be seen in recent ups and downs of stock markets, with the bullish view that low-energy-price led growth may help global equities, challenged by the opinion that oil and gas companies, a significant component of global markets, will suffer at least in the short term from the lower price (some companies may in the medium-to-longer term benefit from the reduction in competition).

Our view is that, on balance, the drop in the oil price should be a net benefit to investors. However, the change heralded by the decline does mean we have to reappraise some of the positions we have been holding:

  • A low oil price means lower inflation, which pushes out the timeframe for the US Federal Reserve and other central banks to start hiking interest rates. It may be time to reassess the worth of investing in US Treasury Inflation Protected Securities (TIPS) in light of this.
  • The contagion from the fear of a Venezuelan default has spread to other South American Nations. The consequent decline in the price of South American securities may soon make it time to start investing in the region – a trade we have been mulling for some time as we have waited for a good point of entry.
  • Energy companies, which have been well and truly hammered by the falling price, make up about one third of the UK stock market. We are considering adding more money to UK stocks as a result of the increasing value in this space.

Risk Warnings

Information provided on this site and any opinions expressed are for general use and not personal to your circumstances, nor are they intended to provide specific legal or financial advice. No information on this site should be viewed as an offer or recommendation to dispose of or acquire any investment or undertake any specific transaction. If you are unsure as to the suitability of any investment you should contact a financial planner who will provide tailored advice.

All information provided is based on our understanding of current legislation which is subject to change.

You should remember that the value of investments and the income derived from them may fall as well as rise and you may not get back the full amount you invest. Past performance is not a guide to future performance. Taxation is based on individual circumstances and is subject to change.

This content was generated prior to Turcan Connell Asset Management Limited operating as Tcam.

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