What Oil Means to the Economy Right Now

So in the end Saudi Arabia and Russia couldn’t quite close a deal to prop up the oil price.

That was the suggested possibility when the two got together for the G20 meeting in China early this week.

Oil traders were watching like hawks for any suggestion of which way prices may go. They went down.

Where to for oil from here?

The most likely direction for oil

There’s a chance that September may yet see something of this sort of deal.

OPEC meets later this month. And there’s plenty of oil producing countries that would like to get more dollars per barrel. But it’s probably not going to happen.

That means prices will be left to the market. So the most likely outcome for oil is for it to build a sideways range.

That’s because any move up will be met with selling as producers lock higher prices in.

But the downside in oil looks a less frightening than it did to some at the start of the year.

One of my colleagues ran some numbers on oil using the West Texas benchmark. He found that the rally in oil from the low in February to the high in June was a rise of 98%.

There has never before been a bear market rally in West Texas Light Crude of nearly 100%.  Point being: we view that as some sort of end to the previous big run down since 2014.

So, oil is unlikely to be particularly volatile for the near term. That doesn’t give us a trend to capitalise on from a trading perspective. You’ll likely have a better chance of making money elsewhere.

Forecasting the future farther out

But it’s a little farther out in time where things get interesting. Here’s why.

The bear market in oil over the last two years has swiped off billions in ongoing exploration.

Global spending on that was US$100 billion in 2014, according to Bloomberg. It’ll be about US$40 billion this year.

That’s one mighty big drop off.

This is happening because oil producers are keeping their money close to hand for the short term. There’s not enough cash flow going through their businesses to invest heavily with the future in mind.

That makes sense for each company individually. You can only take each business day as it comes.

But across the industry it means the oil reserves being run down now aren’t being replaced with new discoveries.

Bloomberg says that in 2015 explorers only discovered a tenth as much oil as they have annually since 1960. They reckon they’ll find even less this year.

Yep, it’s the old supply and demand dynamic at work. At some point — and ‘when’ is the big question — this is going to come back and bite.

Commodities can move in big swings

The lag time for this to take effect seems reasonably long.

Bloomberg cites a Norwegian analyst who says the wipeout in exploration won’t really affect prices for another 10 years — around 2026.

Don’t take that as gospel. That’s just a forecast amongst thousands. Anything could happen to make it earlier.

But you’ll want to be paying attention when oil starts rising. Rising oil prices have a high correlation with recessions. That’s according to recent research from the US Federal Reserve.

They found substantial increase in the price of oil preceded nine of the last 10 recessions in the US.

This makes intuitive sense. Higher energy prices put a heavier cost burden on the economy. It also stokes inflationary pressure.

The flipside is, of course, when energy prices are low it can give the economy a heavy boost.

Over at Cycles, Trends and Forecasts we said as much in our September issue last year.

In fact, we went as far to say the shale oil and gas boom in America may possibly be THE most bullish development to come out of the US in decades ­— if not ever.

In light of that call, it was interesting that Florida newspaper The Sun Sentinel recently reported gasoline consumption has jumped up the state.

To quote, ‘The low gas prices meant consumers had more money to spend, which led to more jobs, which led to more driving.’

I might point out at this point that Royal Bank of Scotland advised their clients to ‘sell everything’ earlier in the year. They were expecting some sort of deflationary depression.

Today, US stocks are currently trading around all-time highs.

The US economy is a lot stronger than most people think. But investors are led to suppose otherwise because they pay so much attention to worthless periphery indicators.

If you want to know how to forecast the economy, you have to start by studying the right causal factors. To learn how to do that, go here.

Regards,

Callum Newman,
Associate Editor, Cycles, Trends and Forecasts

From the Port Phillip Publishing Library

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