The market is freaking out about crashing oil prices – here’s why

Markets across the globe have taken a pounding.

The S&P 500 saw one of its biggest one-day percentage falls of the past year, dropping 1.8%. The Nikkei tumbled by more than 3% this morning.

The slide is being blamed largely on a further collapse in the oil price. The US benchmark, WTI, fell below $50 a barrel yesterday for the first time in five and a half years.

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But isn't a slide in oil prices a good thing? Yes and no.

Lower oil prices can be very good news. But bursting bubbles which is what this is starting to look like tend to inflict a lot of collateral damage.

Here's why.

The trouble with oil there's too much of it

Let's be clear here. A lower oil price is better than a higher one, certainly for most developed economies. Developed economies tend to be consumer economies. Lower oil prices mean more money for consumers and less for producers.

However, it's complicated. I'll try to explain why. Consider computers. Your smartphone has more power than a skyscraper full of computers did in the 1970s. It gives you access to more information than a library's worth of encyclopaedias. Yet it doesn't cost the same as a skyscraper, or even a library.

This is all down to efficiency gains. Clever people invested time and money in finding more productive ways of doing all these things. Computers got smaller, chips got more powerful in short, we made better use of the resources available to us, resulting in an improvement in the quality of life for most people, and no real loss to anyone else.

The makers of smartphones make a profit, and the consumers of smartphones have a device that conceivably replaces their landline, their stereo, and acres of shelf space everyone's happy. This is positive' deflation, if you like.

This isn't what's happened with oil.

It's true that high oil prices have encouraged more energy efficiency. Planes and cars are lighter and go further per gallon. Those are good improvements investments that produce a permanent efficiency gain.

But an efficiency-driven drop in demand isn't the fundamental reason for the falling oil price. Nor is it a drop in demand due to a slowing global economy that might be part of the story, but it's not the main issue.

No, the real problem is that there is simply too much oil. And this is where the bad news side of the story comes in.

A definition of bubbles taking great big punts on high-risk assets

This last aspect of the definition is important. We've all made investments that have gone wrong that's par for the course. The key to a bubble is that investors are staking lots of money (often borrowed money) on high-risk investments usually without fully realising just how much risk they are taking.

From the bubbles of history to the dotcom bubble and the housing bubble, this is how bubbles and crashes have unfolded. And now it's happening in the oil market.

High oil prices convinced companies to take on more challenging and expensive projects to seek out oil in ever-more exotic areas. Meanwhile, incredibly low interest rates meant that investors were falling over themselves to lend or invest in projects promising any sort of return.

Combine that with the exciting new technology of shale extraction in the US, and you have a recipe for an investment boom and bubble. This is why such a high proportion of the junk bond (high-yield) market around 16% is accounted for by energy-related bonds. That's quadruple the proportion they accounted for ten years ago.

The price of getting shale oil out of the ground is falling all the time. And technological advances have also helped with deep-water drilling and all the other exotic' extraction processes. But many, if not all, of these projects were funded on the assumption that the oil price would remain above $100 a barrel or certainly no lower than $75. Now we're in uncharted territory.

And no one wants to reduce production. If anything, all the oil producers and exporters are competing to sell more oil because they need to flog more barrels to compensate for the drop in the price per barrel.

As Steve Russell of Ruffer pointed out at our Christmas roundtable (it's a belter, make sure to read it if you haven't already), the oil price crash is a direct result of the "slow poison" of zero interest rates. Cheap money encouraged over-investment, and now we're seeing the results.

In short, capital has been misallocated', as the Austrian economists might put it. And when capital is misallocated, things blow up.

Bubbles aren't all bad news

A similar story is happening with oil. Improved technologies allowing access to shale won't go away. And we'll be very glad of the benefits in the longer run certain sectors in the US have already benefited from an industrial renaissance due to lower energy prices.

But until the oil price stabilises which could be even further down than it is already markets are going to remain jittery, and eventually we're bound to see some casualties.

We've been writing a lot about the falling oil price in MoneyWeek magazine recently. You can find out more about the recent tumble and how to play it here.

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