By Michael McCarthy 

Oil prices continue their slide, hit by a perfect storm. Undisciplined production increases, a weak demand scenario based on China and a stronger USD are combining to drive oil prices towards the lowest levels in six years. Share investors are focused on the negative implications at the moment, and stocks are falling with energy prices. However, at some stage investors will have to acknowledge the elephant in the room - for most companies, lower energy costs means higher profits.

To put the recent moves in perspective, here’s the weekly chart for the last nine years:

Over the last decade oil spent most of the time trading between $70 and $110. The break out of range late in 2014 saw a dramatic re-pricing. While momentum is clearly negative, the factors pushing oil lower are not as clear cut as the market action suggests.

Looking at the factors one by one:


Concern about slowing growth in China is one of the key factors cited by oil bears. GDP growth has slowed considerably, although more recently has shown signs of levelling off. These more positive developments are currently ignored, with even formerly reputable analysts questioning the accuracy of data. Accepting the numbers when they confirm a market view, then rejecting the numbers as a “fudge” when they don’t is an intellectually dishonest exercise. At some stage this gap must be closed, and will be supportive of oil prices.

On the other hand, little is made of the surprisingly positive growth numbers across Europe. Inflation remains low, but economic growth in general and industrial production in particular is better than expected. This may not be fully reflected in Brent crude pricing.

Share market investors are currently reacting to the “signal” that lower oil prices are allegedly sending about overall demand. However, there is ample evidence to suggest it is the other side of the market driving the falls.


Increases in supply are the likely real cause of the lower prices. At the moment, every significant global producer is up and running, with perhaps only Syrian and Libyan producing at less than capacity.

OPEC is broken. The cartel can no longer maintain discipline among its members, and formally abandoned its quota system last week. The largest producing member, Saudi Arabia, has vowed to increase production with the intent of driving high cost producers out of the market. This is largely a hollow threat, as most Saudi reserves are heavy, sour crude, as opposed to the most sought light, sweet grades.

However, it is clear the Saudis mean business. The targets are likely the quota cheats, as well as the new shale oil producers in the US. US production is responding rationally to the lower prices, with the onshore rig count dropping from around 1,800 last year to around 800 now. However, dependence on oil revenues may mean other nations’ responses are less rational.

Russia and Venezuela cannot afford to slow production given the dependence of the governments on oil revenues. Budgets will not balance at current lower oil prices, but stopping or slowing production will only make the budget hole larger in the short term. There are other oil producing countries with similar dynamics.

These non-economic producers could be the real reason energy prices continue to tumble. While they are not responding to lower prices with lower production oil prices are unlikely to recover quickly. However, governments fall, regimes change and economies adjust over time. In the shorter term, there are enough rational agents in global energy production for a turn in the supply/demand equation.

Implications for shares

This supply side driven weakness in energy is good news for companies – with the obvious exception of the energy producers and explorers. Heavy energy users – transport (especially airlines), manufacturing, aluminium production – are already benefitting. This will start to show up in the February results season. Investors with an eye to the long  term will likely have these sectors on their radar.