The world is hard to understand, but as human beings we don’t like to look stupid. To get round these opposing forces we create stories; they simplify the world and allow us to pontificate with confidence in front of clients and at dinner parties.
Today the story seems to be: ‘China is slowing down, they want less oil, the oil price is going down and this is bad for everyone.’ The natural extension of this is to interpret a fall in the oil price as telling us something about how bad global growth is.
How much has the oil price told us about global growth in the past? Not a great deal.
Looking at year on year changes you can see a concurrent fall in both oil and growth in 2008, and perhaps an increase in both around 2000, but the relationship looks weak.
This shouldn’t be a surprise to anyone. Oil is just one, albeit important, component of the world economy.
Oil is a commodity; its price is determined by demand but also by its supply. In fact only a couple of months ago it was the supply that people were focusing on. The old story was: ‘the high oil price in the late 2000s caused an increase in production including the innovations of shale gas, OPEC have not cut production, and now there is too much oil. This is why the price is falling.’
Both last year’s story and this year’s story have elements of truth. It is supply and demand that matter and, as Woody Brock of Strategic Economic Decisions has long pointed out, both the supply and demand curve for oil are steep, i.e. the market looks more like the chart on the right below than the chart of the left. Slight changes in quantity demanded or supplied lead to large changes in price.
The demand curve is steep because it is hard for most companies and individuals to quickly change how much oil they use in response to a change in price. The supply curve is steep because, despite the much highlighted flexibility of shale production, it is still reasonably hard to reduce production quickly. Brock notes that even more important for supply is the fact that many oil producing nations aren’t profit maximisers but revenue maximisers. Their objective is to raise cash (for example, in countries that need to finance budgets) and so if the price falls, they need to produce more, not less.
Demand and supply matter, and they result in heightened volatility, but because the Chinese equity market and the oil price have fallen at the same time we have changed our story today to focus entirely on demand.
This would be flawed, as would thinking that a fall in oil prices will necessarily be a bad thing for growth in the future. More companies in the world buy oil than produce it. They, like individuals filling up their cars at the pumps, have just had a cut in costs. This should be a good thing.
Finally, it is worth keeping in mind that even if the oil price is telling you about what will happen to global growth (or even what has happened), there are some additional considerations: GDP is not the same as company profits, nor do company profits alone tell you about stock market returns – except over the very long term (as I discussed here). Stories are fun and comforting; unfortunately, in the wold of investments the concept of Occam’s razor (that the simplest explanation is always the best) does not always hold.