In our last installment, we reflected on the economic forces of inflation and deflation. Governments around the world prefer a bit of inflation for a number of reasons. In particular, it is simply easier to raise taxes in an inflationary environment. The world markets, however, are serving up deflation, largely due to supply widely exceeding demand in many areas. This most recent calendar quarter brought more downward economic pressure as crude oil prices have continued their slide from the $85-100 per barrel range all the way down to less than $50. While we as individuals enjoy this at the gas pumps, the stock market has not shown the same enthusiasm. Rather, it irritates lingering concerns and raises some new ones.

While many people believe that the price of crude oil is determined purely by the market forces of supply and demand, this is not a complete viewpoint. Oil producing companies and nations do make agreements amongst each other regarding how much oil supply will be offered and at what price. This collaborative approach kept crude oil in a fairly predictable and profitable price range. The predictability of oil prices has helped take some of the boom and bust effect out of oil exploration and production.

Advances in the US fracking process has been a disruptive factor in the status quo. As a result of this sometimes controversial drilling method, the US has added considerable amounts of crude oil to the world’s markets. Since the US producers are not typically part of the oil production negotiations, other oil producing nations are facing two very real outcomes:

1. Loss of revenues due to declining prices.

2. Loss of market share due to increasing domestic supplies.

These outcomes are causing a ripple of problems for a number of nations. Two nations in particular, Saudi Arabia and Venezuela, rely on oil exports to fund social stability and status quo amongst their citizens.  Russia, too, has been heavily impacted. The loss of revenues from oil production coupled with sanctions resulting from their conflict with the Ukraine has had a double-whammy effect. In recent weeks, the Russian Ruble has plummeted. This plunge is causing significant price inflation for Russian citizens purchasing imported items. This set of issues raises concerns for geopolitical risks that might develop when a population can no longer be appeased with government money.

A separate concern for the markets is much closer to home. It is believed by some that selected domestic oil exploration and production companies have taken on substantial amounts of debt in their efforts to grow their business. While these higher debt levels can be manageable when oil prices are high, fears of insolvency rise as the price of oil falls. The potential for wide-ranging bond defaults has subsequently helped drive down stock prices for many companies in this sector.

Lastly, the declining price of crude oil feeds into the overall theme of commodity deflation that has been at work since mid-July. While on one hand declining commodity prices can be positive in that it reduces expenses, the converse is that it is also indicative of declining demand for raw materials. This is often equivocated with slowing economic production. From this, recessionary concerns re-emerge at a time when economic stimulus has been tremendous.

This, then, shows us the potentially slippery slope of falling oil prices. It also reminds us of the interconnection amongst countries of the world and global financial markets. What benefits one may be to the disadvantage of another. Over the course of my life, I have come to accept that eventually reality prevails by reversing any distortions caused by the few. Such will be the case if crude oil prices have been maintained too high for too long. Until then, we will continue to be alert for the opportunities presented to us and take risk-measured actions as appropriate.

Paul Kluskowski