What lower crude prices mean

GLOBAL crude oil prices have fallen since the beginning of the year despite the political turmoil engulfing the oil-and-gas producing regions of the world.

The price of West Texas Intermediate (WTI) and Brent has dropped 7.01% and 12.24% respectively since the beginning of the year.

What is especially interesting is that the premium between WTI, which is the benchmark for US crude, and Brent, used as a global benchmark, has narrowed over recent years. There is now less than US$5 difference between the two benchmarks.

It used to be that WTI would trail Brent by a premium of more than US$10-US$15 whenever the Middle East erupted in another cycle of violence.

The last time that happened was in June when Islamic militants from Islamic State in Iraq and Syria (ISIS) advanced north into Kurdish-held areas of Iraq and made gains in Syria.

But now, economic fundamentals have taken over. The recent data from China shows that growth in the world’s second-largest economy is still moderating.

The eurozone is still struggling with signs of deflation. Only in the United States is growth seen to be steadier.

China’s industrial production rose 6.9% in August, the weakest it has been since 2008. This is contrast to the median estimate of economists in a Bloomberg survey for an 8.8% gain.

In Malaysia, the weakening crude oil price will negatively impact exports, trade balance and gross domestic product (GDP) growth. However, it will be somewhat positive on the Government’s finance and headline inflation, says HLIB Research.

Lower prices in crude oil and palm oil would translate to smaller export earnings for the second half of 2014.

Meanwhile, Alliance Research chief economist Manokaran Mottain says the weakening crude oil prices is likely to relieve pressure for the Government to not rush into new mechanisms of subsidy rationalisation.

“Going forward we are seeing the softening of domestic economic growth in view of the uncertainties in the advanced economies. So, I don’t expect subsidy rationalisation for now as it will only raise inflationary prices which in turn will trim domestic demand,” he says.

With global prices on a downtrend, there should be no urgency for the Government to rationalise subsidies for now, he adds.

“Presumably, if the decline or downtrend continues below US$90 it gives the govenment some leeway to tweak its subsidy rationalisation plans,” adds Manokaran.

If WTI price drifts towards US$90 per barrel, and all holds equal, the Government will suffer a net loss of around RM2bil to RM3bil, says HLIB.

“Nevertheless, we are still confident that the 3.5% budget deficit to GDP target for this year is achievable given the impressive direct tax collection after stricter enforcement,” it says.

As at end-2013, oil revenue made up for 30.6% of the Government’s total revenue. However, the Government has been taking efforts to reduce its reliance on direct income, like oil revenue, and instead focus on increasing its indirect income.

The impending introduction and implementation of the goods and services tax (GST) is the Government’s way of diversifying its revenue base.

“The fear of lower revenue in the future will likely make the Government realise that they have to broaden their tax base,” Manokaran says.

He adds that although Malaysia will still be dependent on revenue from the oil and gas sector, moving forwards it should be reduced especially with the GST coming into play.

Theoretically, in times of turmoil or uncertainty, commodity prices will rise in anticipation of limited supply.

According to the demand and supply equilibrium, a lack of supply would create higher demand for a product and hence push prices up.

“Each time there is a geopolitical concern, prices of commodity should rise,” says Manokaran.

However, this is not the case for crude oil. Despite the ongoing geopolitical risks, crude oil price has been on a downtrend.

One such reason for this is the increasing production from shale oil and gas fields in the US while crude oil consumption relatively fell against production rate.

The temporary and fragile ceasefire between Russia and Ukraine has also relieved expectations of a disruption in oil supply.

In a recent note, HLIB says: “Notwithstanding the ongoing geopolitical tensions in the Middle East, global crude oil production-consumption gap has been less volatile, partly thanks to ample global crude supply.”

Another point to note is that the bigger economies such as China have been moderating and is facing challenges in achieving its targeted gross domestic product (GDP) growth of 7.5%.

Also, the economic outlook in the eurozone has been less than promising, prompting the European Central Bank to further cut interest rates and launch an additional stimulus.

All of this could lead to slower crude oil demand in the near term, says HLIB.

“The moderating economy itself is resulting in an adjustment in price via the reduction in demand,” says Manokaran.

Furthermore, the appreciating US dollar has contributed to the drop in crude oil prices.

Since July 2014, the US dollar index has appreciated by 6.2%, its highest since July 2010 mainly due to increasing expectations of an early Federal Reserve rate hike.

HLIB says the weakness in other major economies like the eurozone, Japan and China has also led to a divergence in monetary policies with the Fed, resulting in a stronger US dollar.

“As crude oil is prices in US dollars, crude oil price is therefore negatively correlated with US dollar index,” it says.

Moving forwards, HLIB expects the “ample supply-weak demand” situation to continue into the fourth quarter of 2015 and early part of 2015.

“Putting aside acute geopolitical risk, there is still lack of catalysts to lift crude oil prices to higher levels,” it says.

The US Energy Information Administration (EIA) has forecasted average crude oil (WTI) price of US$100.45 per barrel in 2014 and US$96.08 per barrel in 2015, on the back of broadly balanced crude oil production and consumption as the global economic growth outlook remains moderate.

Latest projections by the EIA indicated a mild production rise by 1.7% to 91.65 million barrels per day (mbpd) in 2014, against consumption of 91.56 mbpd, and 1.5% to 92.98 mbpd in 2015 against consumption of 92.96 mbpd.

“Given the latest developments, we believe there is some downside risk to the EIA’s forecasts,” says HLIB.

At the same time, production of shale oil and gas in the US is expected to continue on an uptrend, as more capacities come on stream. This will add more pressure to the existing ample supply.

“In terms of demand, both the Chinese and eurozone economies may not strengthen drastically despite series of measures, pointing to still weak crude oil consumption story,” it says.

HLIB expects the US dollar to further appreciate, especially after the Fed winds up its third quantitative easing in October 2014, leading to the divergence of global monetary policy.

BY WONG WEI-SHEN