On the drop in Oil prices, Deflation and the future of Green Energy

As an analyst, one of my job is to read on the news and events in the financial markets, make some sense of it and visualize the future while developing a strategy around how things would unfold in order to be in a more advantageous position. With the internet, it is not really that difficult to do these nowadays.

It is already no hidden secret that the Federal Reserve is planning to raise interest rates as many have predicted the low interest rates environment would not linger. My view is that interest rates are bound to increase but in small steps and at gradual inclinations, and even if it rises, it is not expected to even go up to as high as in the past due to the credit driven economic growth that has shown capable in sustaining job gains. However, since October oil prices have dropped by more than half in just a matter of months and bankers have speculated on more downtrend in the near future. It is not just oil that have dropped, as commodity prices from iron ore to cotton have fallen from their high points. Granted the initial reaction in the drop in oil prices have generally been positive, with some speculating the potential for GDP gains for most countries from the Philippines to the United States. However, one tend to forget that consumption forms just one part of GDP. Investments form another. A dip in oil prices might loosen up purse strings for consumers but whether they will purchase and consume more goods is another question. A savings does not necessarily equate an equivalent amount of spending elsewhere. But what will happen for sure is the drop in business investments.

Already happening are the large oil and gas projects that have been drafted and are now being cancelled as it no longer becomes feasible. Countries from Norway to Qatar are postponing or stopping work on offshore oil rigs to energy projects. These are some of the known projects cancelled and their expected value:
1) Qatar and Shell petrochemical project: $6.5 billion
2) Deferment in Canada Oil Sands projects: $12 billion
3) Premier Oil offshore Falklands Island project: $2 billion

The above are just some of the disclosed projects that are being deferred or cancelled. Taking the Canadian oil sands project as an example, should $12 billion of projects be postponed, that could translate to probably a few billions loss of investments. Add a few more billion in the loss of contracts by exploration companies and another few more billion in cancelled mining projects because of the drop in commodities, they could negate out the savings that Canadian motorists could save, which is expected to be about $12 billion. Another thing is that motorists who use public transport would only see meaningful savings if public transit prices are reduced. My point here is that the savings in petrol stations might not translate to meaningful gains in GDP and with the drop in investments, there could be an overall drop in GDP.

As we all know, a drop in GDP generally could lead to recession and ultimately deflation, especially since the consumer price index could fall with the corresponding drop in retail oil prices. The United States already announced a drop of 0.9% in retail sales for the month of December yesterday with gas station receipts dropping 6.5%. Could this indicate that consumerism is not enough to counter the savings from gas station receipts? While the drop in oil prices might be good for the majority of consumers it definitely ain’t good news for those working in the oil and gas industry. That means all the engineers, geologists, and workers conducting everything from exploration to drilling to refining. Then there are the supplementary jobs from lawyers to bankers that help oil and gas companies set up operations and financing, whose jobs are also in peril. These people who probably are some high-earners would see a drop or even loss in income. Thus I do not see it all as good news even though it might be great for me when I fill up my gas next time.

Since I mentioned deflation previously, I figured to make it even more relevant in today’s context. China, which has been the main driver for growth for the last decade, has mentioned of slower growth as the new normal. With that being said, while 7.5% GDP growth is less than half of what China used to experience, it should be noted that in absolute number terms 7.5% growth on the back of a $9.24 trillion economy means an expansion of $693 billion in the GDP. Consider that in 1985 when China’s economy managed a 15.2% GDP growth, the GDP figure was but $306.7 billion. But digressing from the fact that China’s economy is facing slower growth, it is also gradually transforming from an investment driven to a consumption oriented economy and that means it is driving down raw materials prices. Thus prices for raw materials would be expected to drop all around the world. The next thing to note is the continuous drop in value of the Euro with some calling for the Euro to drop to parity (ie. 1-1) with the US Dollar. Then to add to the whole gloom, Japan is pushing ahead with monetary easing in order to chase that seemingly distant inflation resulting in a drop of the Yen. The drop in Yen and Euro, 2 major world currencies could ‘export’ deflation into the United States by making imported goods in the United States cheaper. That BMW from Germany and Canon cameras from Japan might be cheaper in the future in absolute US Dollar terms.

Now we come back to the issue of the Federal Reserve planning to raise interest rates. That means consumers in the know might be raising funds or saving more to pay down credit card debts, mortgages and car loans. Businesses would also be more stringent in managing lines of credit, thus in the short run up to the expectations of interest rates rising, businesses and consumers could save more, and spend less, creating a sign of deflation. Would the Federal Reserve still be bent on raising interest rates then, or would they want to avoid the spiralling deflationary scenario that has hit Japan for the last 2 decades?

What has deflation and the drop in oil prices got to do with green energy or also referred to as cleantech nowadays? Well green energy investments have been driven partly as a result of high oil prices. But not solely for that reason as I think there is also fear of global warming and how we, humans, as a whole have stressed the Earth too much for its own good. Thus if hedge funds are smart about it, rather than placing long bets on oil prices to o back up, they should put their money on cleantech ventures since it could also be considered the contrarian investment theme to oil and gas as they are somewhat supplementary.

And to tie the 3 together, the drop in oil prices means that hard-to-obtain oil might becomes less feasible investments but I doubt the developed economies might want to face the prospect of another high oil price scenario with no alternatives. The savings in oil consumption could instead go to building solar and wind facilities, converting public transport to electric means and households could do the part by spending on renewable sources of energy. That way one is truly saving for the future! Deflation might even help in spurring this by reducing the cost of raw materials, the cost of building solar modules and any investments in renewable energy might be reduced, making projects more attractive for investors. Along the way, there could be a change in the way we power the home we live in and alter the way we live, creating that better environment.

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