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Will cheaper oil grease the wheels of global growth?

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Summary

Oil prices are down by one-third since the highs of October. While it may mean cheaper petrol at the pump, what does it mean for your investments?

2 min read

The shrinking cost of ‘black gold’ could help keep prices low, boosting household spending, bolstering the economy and benefitting investors.

Oil prices have fallen 30% in less than two months – plummeting from almost $90 a barrel to under $60, its lowest level in over a year.

This could very well provide a small but important boost for investors as it means lower costs for companies, improving their profits.

Coutts Investment Strategist Lilian Chovin says, “The cost of oil contributes to the price of fuel used by factories and it’s a key expense in transportation as companies distribute their products.

“If a product becomes cheaper to produce then a company’s margins improve and this makes a difference to its bottom line. Share prices for more profitable companies tend to rise, allowing for potentially higher dividends for investors.”

Lower oil prices can also put more money into people’s pockets, boosting consumer spending which is also good for companies. It can lead to lower household energy bills and lower prices at the pumps – as shown by Asda, Morrisons and Sainsbury’s reducing what they charge at their petrol stations.

 

More efficient oil companies avoid the worst

On the flip side, a lower oil price can create challenges for the energy sector, which makes up 17% of the FTSE 100.

Lower prices tend to mean lower margins for oil companies, and the price per barrel can even fall to levels where it’s no longer profitable to extract and process.

But this is less of a problem than it was in the past. Many oil companies have become more efficient at extracting and processing oil and have diversified their businesses to rely less on oil prices.

This has helped make them less vulnerable to weaker prices and helped shield us from any negative effects of the oil price plunge on our investments.

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“If a product becomes cheaper to produce then a company’s margins improve and this makes a difference to its bottom line. Share prices for more profitable companies tend to rise, allowing for potentially higher dividends for investors.”
Lilian Chovin, Coutts Investment Strategist

A slower approach to interest rate rises

By keeping costs and prices down, lower oil prices also act as a dampener on inflation and this has a knock-on effect on interest rates. As a result, we could see a slower approach to interest rate rises from central banks over time to keep the economy under control.

This is also potentially good for investors. Low rates encourage companies to expand, making it easier to finance new projects and generate new profits. They can also make consumers more likely to spend rather than save, further encouraging consumer spending.

In a sign that interest rate rises might slow down, US Federal Reserve (Fed) chairman Jerome Powell gave a speech last week in which he hinted that the bank’s run of rate hikes might become less aggressive than originally planned.

That is by no means certain though. Markets rose on Powell’s comments but analysts were quick to call it an overreaction, pointing out that the rest of Powell’s speech contained little evidence of a change in the Fed’s plans. Markets are still pricing-in an expected rate rise this month, although there are now expectations for fewer hikes next year.

 

Why has the oil price fallen?

Oil producers pumped furiously when President Trump announced sanctions on Iran over the summer. They were worried the commodity would quickly become harder to get hold of and, consequently, generate supply concerns.

But then President Trump announced exemptions from the sanctions for eight countries, including some of Iran’s largest customers. This meant the supply issue was not going to be anywhere near as bad, and there was suddenly an excess of oil in the market. So prices fell.

In the meantime, US shale output has remained high leading to rising US reserves. America’s crude oil stocks have increased sharply in recent weeks – from just below 400 million barrels to around 450 million.

All eyes are now on the OPEC meeting on 6 December to see if members make moves to curb production levels. This is not necessarily a foregone conclusion. Recent comments from OPEC oil ministers show an intention to stick to their original strategy of ensuring an appropriate market balance.

Past performance should not be taken as a guide to future performance. The value of investments, and the income from them, can go down as well as up, and you may not recover the amount of your original investment.

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