Why cheaper oil is bad news for the economy

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Oil's recent slump may not be good news for us commodity bulls at MoneyWeek, but the equity bulls are delighted. Stock market indices are surging to all time highs, driven by the belief that cheaper crude is just the boost that the global economy needs to avoid a US-led slowdown or worse.

Yet to us, this latest rally seems a classic case of buyers having their cake and eating it. As Christopher Wood of CLSA puts it: "It was bullish for stocks when the oil price was rising. It is now bullish when oil has started declining. Nothing could better illustrate the present sentiment among investors, which is to want it both ways."

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To be fair, there are some obvious reasons why markets can interpret cheaper oil as bullish. But considered in more detail, these reasons don't hold up at all

Let's start with the positives. Lower energy prices mean that headline inflation should fall (subject to other prices eg food not taking off).

In addition, lower fuel prices also mean more money in consumers' pockets, which should bolster spending on non-energy items. This would be good for corporate profits (except energy-company profits, of course). Thus the fallout from the US housing market slowdown might be negated.

Combine these arguments and you get the Goldilocks scenario so beloved by markets: low inflation twinned with decent growth.

Some pundits also point to geopolitical benefits from cheaper oil. The sudden fall in petrodollars could damage many unsavoury regimes around the world, such as Iran. The commensurate improvement in global security would be great news all round including for markets.

But even on its own merits, the optimistic viewpoint has its problems. For example, headline inflation might fall, but the resurgent consumer spending could well support or drive up core inflation. Since central bankers worry about core more than headline inflation, cheaper oil could perversely mean higher interest rates.

Meanwhile, the geopolitical argument is optimistic. Even if oil were to topple back to $40/barrel which looks unlikely oil-producing countries are far better off than they were for years. It would take rock-bottom oil prices to really undermine their power.

As a side issue, while Iran might be weakened in the implausible scenario of sub-$20 prices, so might friendly' regimes. Saudi Arabia needs increasing amounts of oil money to support its extensive government-spending programmes. Otherwise, an underemployed and deeply-frustrated section of its populace might decide that it's an excellent idea to string up the House of Saud and replace them with a Wahhabist theocracy.

And there are plenty of other reasons to think lower oil prices are not a panacea for markets. If the petrodollars dry up, it could well be bad news for asset prices in general. Abundant oil money is part of the flood of liquidity that has seen virtually all assets around the globe ascend in lockstep for years: who knows what will happen if this spigot is turned off?

Then there's the supply issue. Expensive oil encourages investment in new production and in alternative sources of energy. The weaker the price, the less investment in future supply there'll be. This merely stores up problems for further down the line, when industrialising nations will require more and more natural resources. Put simply, $50/barrel oil now makes it even more likely that we'll see $100/barrel oil in a few years' time.

But the biggest immediate cause for concern lies in one question: exactly why is oil is falling? Bear in mind that the bull run has been down to three factors. One reason is security fears, another is speculative money from hedge funds and so forth, and the third is a very real imbalance between supply and demand. Which of these have vanished?

Those security fears certainly haven't. Indeed they seem to be getting worse. Speculative money is still abundant, but the lack of hurricanes in the Gulf of Mexico will have meant plenty of failed bets on oil this summer and probably led to many speculators pulling out of the market. So some loss of speculative interest may have played a part in the slump.

But it seems probable that the main cause of the drop has been a weakening in demand, caused by a sharply slowing economy. So far, data to prove this idea are in short supply. (As ever in economics, solid evidence has an engaging habit of becoming available too late to be useful). However, there are signs of slackening interest in industrial commodities across the board. For example, highly-economically sensitive copper has been in a downtrend since May. Backing this up, plenty of non-market leading indicators in the US are pointing to a slowdown or worse.

Oil led the commodities complex up as demand boomed. It may now be leading the economy down into a bust. In which case, the net impact will be weaker equities in the near-term and pricier oil in the long-term (thanks to lack of investment). In short, investors and markets should not cheer its decline too soon...

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The FTSE 100 closed at a fresh five and a half year high yesterday, up 15 points to 6,172. Drax was the biggest climber of the day, benefiting from the news of cracked pipes at rival British Energy's nuclear power plants - which news saw the latter's share price fall nearly 25%. For a full market report, see: London market close

Across the Channel, the Paris CAC-40 closed marginally higher at 5,361 - a gain of 8 points - and the Frankfurt DAX-30 was 12 points firmer, ending the day at 6,186.

On Wall Street, stocks also ended Monday's session higher. The Dow Jones logged a new record close of 11,980 after rising 20 points on the back of strength from Alcoa and Exxon Mobil. The Nasdaq was 6 points higher, at 2,363. And the S&P 500 ended the day 3 points higher, at 1,369.

In Asia, the Nikkei fell 81 points to close at 16,611 today.

Crude oil was back above $60 this morning, last trading at $60.07. Brent spot was at $59.89 in London.

Spot gold hit a new two-week high of $597.50 overnight, and was trading at $597.10 this morning.

And in London today, beleagured healthcare software company iSoft said it was discussing its possible sale with a number of financial investors and other firms. The company also announced that problems surrounding its contract to supply the NHS with a new computer system would see full-year revenues fall by up to 15%. Shares in iSoft rose by as much as 6.7% in early trading.

And our two recommended articles for today...

Have hedge funds lived up to the hype?

- It all sounded so good: hedge funds would cost us more in fees but would make absolute returns whatever the market conditions. But are they - like private equity - just a complicated way of failing to beat the market? asks Merryn Somerset-Webb. For more on whether hedge funds and private equity should have a place in your investment strategy, read: Have hedge funds lived up to the hype?

What's the greatest threat to the financial system?

- Contrary to conventional wisdom, one commentator believes that it is not central bank rate decisions which determine inflation/deflation. What's more, whilst investors and policy-makers are worrying about rate hikes and inflation, they are ignoring a much more serious issue. To find out what it is, see: What's the greatest threat to the financial system?