Why Low Oil Prices are Damaging for the USD and the Financial Markets

Average oil prices are down 25% since the summer, making it all the more challenging for the Fed to reach

It doesn’t matter which asset class you’re trading- everyone’s focus is on the descending oil prices which are having a knock-on effect on the financial markets and global economy. The price of the world’s most frequently traded commodity has thus far fallen over 12% to its lowest point in 7 years. Oil declines are commonly consistent with U.S. dollar strength, but in the last few days there have not been broad-based advances in the greenback. While the USD is resilient versus the commodity currencies, it still struggles to make gains against the euro and Japanese yen.

Traditionally many economists maintain that low oil prices are beneficial for the U.S. economy because they improve consumer spending, but although average oil prices are down 25% since the summer, we have not seen a big trigger in spending. Thus if low oil prices fail to enhance spending then the main effect will be softer profits for energy companies and layoffs in the oil industry.

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Counter forces

Higher oil prices have traditionally been advantageous for the financial markets as oil rich nations used to utilize surplus funds in these markets, but the latest fall in oil prices is now resulting in these countries withdrawing money from the global financial markets. Most oil producing countries, particularly those in the OPEC, are operating a favourably subsidised economy.

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Revenue from the sale of oil is used by the kingdoms or regimes to support social programmes to keep native residents comfortable, but with oil prices collapsing from a high of $115 per barrel in August 2014 to less than $40 now, these economies are severely exposed. Since oil revenues represent the largest contributor to the investments of these territories, they would need a higher oil price to balance their budget in order to meet its spending.

Therefore, if the current oil prices fail to support consumer spending then the fundamental value goes out the window and we need to concentrate on other implications. One of the chief claims against a rate hike this month is low inflation and the 12% drop in oil prices only makes it all the more challenging for the Fed to reach their inflation objectives.

Looking Ahead

So are we near the floor in oil prices as some economists are forecasting? It all depends on how long the suppliers, corporations and countries hold on to their production mandate and absorb the pain. Someone has to surrender for the oil market to bottom out. Until such a time, funds will continue to be pulled out from the markets and the prospect of a US rate hike will make the dollar stronger and oil weaker, adding additional strain on oil prices.

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