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Edward Hadas

The price of oil is a barometer. Friday’s fall of Brent crude to below $100 a barrel, for the first time since February 2011, shows that financial conditions and investor sentiment are bleak.

In theory, the price should say something direct about oil — it might, perhaps, give indications about the cost of production. But crude could be produced in ample supply at around half of today’s level. Nor does the market price dictate the cost of consumption, since users’ bills almost always include a hefty dose of tax or subsidies. And, contrary to theory, the price doesn’t elucidate the balance of supply and demand, which is better studied from the perspective of the producers’ imperfect cartel. The price is, however, an indicator of financial conditions; oil, like fine paintings and property, has become a repository for excess funds. The years of easy credit in the 2000s helped push the dollar price of crude into triple digits. The years of easy monetary policy since the crisis have helped keep the price of a barrel of Brent above $100.

 

Monetary policy has hardly tightened recently, although the big central banks’ money-creating programmes are currently on hold. But lenders’ economic fears have made credit a bit tighter in the last few months. That means there’s less money around to bid up the price of the black stuff. Oil buyers’ economic fears have also intensified. Their changed mood probably explains most of Brent’s 18 per cent price decline since the beginning of May. Oil remains an asset that investors flee when they are worried; they have recently become much more worried.

In theory, the oil price decline will be self-limiting, because it will stimulate economic activity in the global economy. As any energy economist can explain, the additional consumption from richer oil importers should be greater than the consumption decline by poorer exporters. But that theory comes from the same ideal universe in which the price reflects costs, supply and demand. In practice, oil price benefits sink into the morass created by a destructive financial and pyschological whirlwind. The lower bill won’t have much effect in this slough of despond.

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First Published: Jun 04 2012 | 12:01 AM IST

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