How to benefit from falling oil prices

There’s war all across the Middle East. Russia and the West are at loggerheads over Ukraine.

In short, the geopolitical situation is ugly.

And yet the oil price – the commodity you normally associate most with grim news – has fallen hard in recent weeks.

What’s going on?

What’s behind the slide in the oil price?

The price of Brent crude oil has dropped from more than $110 a barrel a couple of months ago, to not far off $100 now.

That might seem odd, given the stand-off with Russia and the horrors in Iraq. But awful as these conflicts are, they have little impact on the oil price.

Russia is a big oil exporter. But as Julian Jessop of Capital Economics points out, the oil trade matters too much to both Russia and Europe to be the victim of sanctions.

And as far as Iraq goes, says Jessop, US intervention has “surely lessened the threat posed by the ‘Islamic State’… and boosted the potential for oil exports from the Kurdish autonomous region. The recent political changes in Baghdad should also increase the chances of more stable governance in Iraq.”

So, the geopolitical picture might be ugly. But as things are, it’s not having a big impact on oil.

Meanwhile, in terms of the fundamentals, there’s enough oil to go around – particularly as the shale oil breakthrough in the US has transformed the supply equation there.

Last month, for example, oil cartel Opec said that demand for its oil in 2015 would fall to its lowest level in six years. That would mark the third demand drop in a row.

That’s not because overall demand for oil is falling. It’s because the US has become such a significant oil producer.

Overall, Jessop reckons the price of Brent could fall as far as $90 a barrel next year.

Who’ll benefit from a lower oil price?

You could bet on oil prices directly if you felt so inclined – there are various exchange-traded funds (ETFs) that enable you to either go ‘long’ or ‘short’ oil.

But I’m not really keen on the idea of directly betting on the oil price. It’s a short-term trade, and in the short run, it’s very easy for things to happen out of the blue that surprise even the smartest forecasters.

I’d rather look at potential long-term bets on a lower or flat oil price – such as favouring the stock markets of countries that will benefit. This is good news for oil-consuming countries, and bad news for producers – it’s another reason to be wary of Russia, for example (although share prices there are so low that they are arguably pricing in lower energy prices – have a read at Merryn’s blog for more on this).

On the other hand, a falling oil price is good news for India’s economy – according to Deutsche Bank, it will save the Indian government around $8bn on its import bill. That’ll help the country to reduce its spending on fuel subsidies. At a time when the government is also trying to reform public spending, that can only be good news.

Meanwhile, falling oil prices would also be good news for Japan, which also relies on imports to meet its energy needs. It’ll also help offset the impact of the rise in the sales tax – you can read more about Japan here.

How a falling oil price could be inflationary

You might also assume that a falling oil price would help to keep inflation under control closer to home. But I wouldn’t be too quick to leap to that conclusion.

As James Ferguson of MacroStrategy Partnership has often noted in the past, a rising oil price is deflationary. It might push prices up in the short run. But in the longer run, it acts as a tax, and harms economic growth. Put simply, if you have to spend more money on petrol, you have less to spend in the shops.

But if the oil price falls, you have more money in your pocket. It’s like cutting taxes. More money in your pocket means more spending, which means more demand, which all else being equal, is inflationary.

So, in the short term, falling oil prices might give Bank of England governor Mark Carney the excuse he wants to keep interest rates right where they are until after the election in May next year. But in the longer run, it makes it more likely that ‘proper’, demand-led inflation will take off.

• This article is taken from our free daily investment email, Money Morning. Sign up to Money Morning here.

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