Why low oil prices are bad for financial markets

The Organization of Petroleum Exporting Countries (OPEC), the world’s biggest oil cartel, decided to not cut crude oil production, pushing oil prices lower to a seven year low. In a meeting held last Friday, OPEC decided to keep production unchanged as Iran maintained plans to boost its output when sanctions against it are lifted next year.

Saudi Arabia, the world’s largest oil producer argued there is little point in OPEC reducing production unless large producers outside the group, including Russia and Mexico, also curb output.

This is good news for India as lower crude oil prices help keep fiscal deficit as well as current account deficit in check. But while fiscal math gets a boost, lower oil prices is bad news for the financial markets and in turn the global economy. This in turn will put pressure on bigger Indian companies who are dependent on global market growth for their revenue.

Higher prices have historically been good for financial markets as oil rich countries used to deploy excess funds in these markets. But a fall in oil prices is now resulting in these countries withdrawing money from the global markets. Reports say that nearly $19 billion has already been withdrawn from the markets. JP Morgan suggests that if confidential arrangements are included, then the withdrawals can touch $50 billion.

For markets, it is thus important to conduct a health check-up of oil economies. Most oil producing countries, especially those in the OPEC are running a highly subsidised economy. Revenue from sale of oil is used by the kingdoms or governments to finance social schemes to keep the local population happy.

With oil prices crashing from a high of $115 per barrel in August 2014 to less than $40 now, these economies are badly exposed. Many of them run a high double digit fiscal deficit. Saudi Arabia for instance, the high oil producing OPEC member runs a fiscal deficit of $21.60 per cent (Read here). Libya runs the highest deficit of 79.1 per cent, Venezuela 24.40 per cent, Iraq 23.1 per cent while in Algeria it stands at 13.90 per cent.

Since oil revenues constitute the biggest contributor to the finances of these countries, they would need a higher crude oil price to balance their budget. It is reported that Saudi Arabia might need an oil price of $105 per barrel to balance their budget. Similarly Venezuela will need oil prices to touch $117.50 per barrel to post a breakeven budget. Nigeria needs an oil price of $112.70 while Libya, the country with the highest deficit would need oil prices to touch $269 per barrel in order to meet its expenditure.  

The reason why analysts feel that oil prices will be lower is because the current OPEC meets failed to not only mention cutting oil production but also there was no mention of maintaining oil production. This gave rise to fears of higher supply from the worst affected economies. Libya for instance is 20 per cent excess capacity (though smaller reserves) which it can use to make its ends meet. Similarly, Iran which has just come out of a ban on oil exports has 20.83 per cent excess capacity while Saudi Arabia has 17.13 per cent.

Venezuela which has the highest oil reserves, higher than Saudi Arabia is battling resources to develop its oil fields. But that might not last for long. Venezuela’s oil minister warned that a failure to reduce the oversupply could cut another $20 off prices next year. Goldman Sachs had also come up with an oil price prediction of $20 per barrel on continued supply.

Possibility of a rate hike by US Federal Reserve will make dollar stronger and oil weaker adding further pressure on oil prices. To add to the problem is the rising production of oil from fracking.

So are we near the bottom as some analysts are projecting. It all depends on how long will the producers, companies and countries hold on to their production schedule and absorb the pain.

Someone has to blink for the oil market to bottom out. Till such time, money will continue to be withdrawn from financial markets.