A welcome relief

Crude oil prices have fallen over 40 per cent since their highs in June 2014. The decline is one of the biggest since the mid-1980s, beaten only by the post-Lehman correction in 2008.

However unlike 2008, the global economy is not in recession, but is in fact currently growing at a modest pace.

The International Monetary Fund (IMF) expects growth to be in the region of 3.5 per cent this year,
with the assumption being that the fall in the price of oil has been caused by changes in the supply and demand dynamic, rather than a collapse in economic activity.

A strong dollar

There are two predominant factors that have influenced this. One of the factors affecting the price of oil has been the strength of the US economy, and consequently the US dollar.

Over the past year, the dollar index (a measure of the movement of the dollar versus the major world currencies including the euro and yen) has risen almost 20 per cent.

Given that expectations remain of the US being the first of the major economies to raise interest rates, consensus opinion is that the US dollar will continue to strengthen on a relative basis. As commodities are priced in dollars, they tend to have an inverse relationship with the US currency.

Thus if the dollar is strengthening versus international currencies, commodities (in this case oil) become relatively more expensive as the purchasing power of the buyers currency is diminished, thereby reducing demand.

Excess supply

The other main factor when analysing the sharp fall in oil is the current state
of oversupply in energy markets. Towards the end of 2014, the Organisation of the Petroleum Exporting Countries (OPEC) refused to cut production levels.

As they are responsible for (circa) 45 per cent of the world's crude oil production, and (circa) 80 per cent of global reserves, this decision led to excess supply in the market place, which saw a sharp correction in crude oil prices.

Whatever the reason may have been for the largest OPEC producer, Saudi Arabia, to refuse to cut production (and there are many theories) it is clear that there continue to be winners and losers from lower energy prices.

Regions that are net exporters of oil will naturally lose out from a lower price and conversely, net importers of oil are set to gain. But when we move beyond the obvious implications and consider what this means to the global consumer, the effects become particularly interesting.

Further impact

Before oil prices dropped sharply, inflationary pressures were mounting on economies to raise interest rates (particularly the US), with many predicting the Federal Reserve would have raised rates by now.

However as energy prices are a significant component of inflation measures, a sharp fall in their prices allowed global monetary policy to remain supportive.

The end result has been that many consumers have essentially experienced a tax cut, as heating and fuel costs decreased without interest rates rising, thus allowing mortgage and rent rates
to remain the same.

With more money in the consumer's pocket, consumption is likely to increase which will have a net positive effect on the global economy.

Indeed, in its recent world economic outlook, the IMF highlighted the collapse in oil prices and the easing of austerity programmes in developed countries, as key reasons global growth will improve over the next two years.

However the global economy continues to remain vulnerable to economic shocks, in an environment where volatility is set to increase. 

Claire Bennison is regional director at Brooks Macdonald in Manchester

She writes a regular in-practice article on asset management for Private Client Adviser

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