The Impact of Oil Prices
Oil prices are driven by three factors, namely supply, demand and market sentiment.
- A fall in oil supply will result in the price of oil moving up as by definition it becomes scarcer. Oil supply is linked to oil production, which means the events that could disrupt production will have a positive impact on the price. Similarly, it is linked to the movement of product, thus any event that may impact oil pipelines or seaborne movement will place upward pressure on the price. Higher oil production will push supply upward, driving down the price because the commodity is less scarce.
- Demand for oil is driven by economic growth and technological change. Strong growth increases the demand for oil as it drives up energy requirements. A fall in economic growth reduces activity and therefore oil demand. Higher growth drives oil prices up and lower growth results in a decline in prices. As a major theme, technological change seems to be moving to reduce the world's dependence on oil for growth, both from an energy generation perspective and in transport - where it remains the largest influence on fuel prices.
- Market sentiment will dictate shorter-term price movements. This is usually related to the expectation of a possible change in the supply or demand dynamics for oil. For example, fears over lower economic growth due to the impact of Covid-19 prevention measures will have a negative effect on expected demand for oil, which will in turn result in the price falling. The Organisation of Petroleum Exporting Countries (OPEC) agreeing on production cuts or a difficult dictator in Libya blocking exports from certain ports will have a negative impact on supply prospects, which will result in the price rising.
Oil prices almost simultaneously received a demand-side shock and a supply-side shock in February and March. The demand shock came in the form of the Covid-19 outbreak which led to the unprecedented lockdown or partial shutdown of all major economies globally. This resulted in oil demand falling sharply - as economic activity slowed, oil requirements came down sharply - particularly because people have stopped moving around. The supply shock came as a result of Russia and OPEC failing to reach an agreement on supply shocks in response to the fall in demand. Saudi Arabia decided to increase oil production in an effort to strong-arm the Russians and to a certain extent the US into a deal to cut supply. This resulted in what is termed a "supply glut".
Positives of low oil prices
Low oil prices are generally regarded as positive for consumers because it translates into lower transport costs. It is also positive for oil-importing countries, like South Africa, from a trade balance perspective and therefore may have a positive impact on their currencies and economic growth. Lower transport prices and a stronger currency could translate into a more benign inflation profile, which will in turn allow central banks to keep interest rates lower for longer - another positive for consumers.
Depending on the business, lower fuel costs and lower interest rates are generally positive for businesses due to lower costs and lower interest expenses which will improve profitability. A stronger rand will support businesses with a large import component attached to them.
Negatives of low oil prices
Low oil prices are regarded as negative for oil-exporting countries. Lower royalty and tax revenue usually translate into less social spending, which is negative from a consumer perspective and bad for economic growth. In the case of oil-importing countries, the stronger currency resulting from lower oil prices will be bad for companies that export product into other markets. It also has a negative impact on companies whose product is tied to the price of oil.
Oil price expectations
Oil prices will remain volatile over the next few weeks and months as uncertainty around the depth of the demand shock following Covid-19 interventions and supply-side negotiations remain erratic. The oil price will only recover sustainably once there is a clearer view of when economic activity will normalise (when lockdown and social distancing measures will end) or OPEC, Russia and the US agree on further supply cuts. While the demand side of the equation remains unclear, we have seen some movement on the supply side. US oil rig counts are already going down and, after agreeing to an initial cut of 10 million barrels per day, it seems that OPEC, Russia and the US are in talks for further production reductions. US shale companies are running losses and most oil-producing nations are running large budget deficits at these levels. There is further upside risk in the form of renewed geopolitical tension in the Middle East - which has been a major source of oil price support for decades.