Oil prices took another nosedive on Thursday on the news that OPEC had refrained from cutting current oil production despite the recent decline in oil prices. The Brent oil price plunged below USD72/bl on Friday morning, leading to a total decline of USD43/bl since the peak in June. The signal from OPEC is clear: it does not want to bear the burden of adjusting production lower to allow for other countries outside OPEC to produce more. So, although the decline in prices is hitting many OPEC countries, OPEC has chosen short-term pain for longer term gain as the price is now falling below the marginal cost of many oil investments in, for example, US shale industry.
The lower oil price is very good news for western consumers (see Strategy: Big drop in oil price to boost consumption, 21 November). In the US, gasoline prices this week fell below USD2.80 per gallon for the first time in four years and a similar development is being seen in Europe, although the weaker euro is dampening the decline. Other commodity prices – including food – are also falling and adding to the downward pressure on inflation.
As we expect oil prices to stay low in the short term, we now forecast inflation will reach 0.1% y/y in December. There is also now a clear risk that euro area inflation could fall to zero or potentially dip into negative territory if oil prices fall further. While in principle this should not be a big problem as it is driven by commodity prices, it may still lead to new headlines about deflation risk and add to the pressure on the ECB. A real challenge for the ECB is that lower inflation also tends to drive wage growth down and hence inflation could easily get stuck at a low level far below 2%. Hence, the further decline in oil contributes further to the probability that the ECB will increase stimulus next year and implement quantitative easing in government bonds. The low inflation pressure was evident in the data for November, when headline inflation stayed at 0.3% y/y and core inflation remained at 0.7% y/y.
Although lower oil prices should be positive for the global economy, it is a bit of a double-edged sword. At some point, the decline in prices could be so big that it causes financial distress in oil exporting countries. Russia in particular seems vulnerable. We do not think we are close to systemic risk but it is increasingly a factor to follow. A big decline in the oil price in 1997-98 was one factor causing pressure on Russia that eventually led to the Russian default in August 1998. We do not believe the situation is as bad today but again it is a factor to follow; not least in the short term as many stock markets have been performing very strongly and some have moved into short-term overbought territory measured on momentum indicators. When this is the case, markets tend to be more sensitive to event risk.
To Read the Entire Report Please Click on the pdf File Below