Cheap Oil: Too Much Of A Good Thing?

By | December 19, 2014 10:18 am

The 40% drop in oil prices over the past 6 months has garnered a lot of attention recently, most of it focused on the economic stimulus lower oil prices should provide the global economy, the impact on currency and fixed-income markets and the increase in economic pain suffered by exporters such as Iran and Russia. In this article, I draw on historical data to assess the potential increase in geopolitical tail risk that lower oil prices may represent. I believe this is an overlooked consequence of lower oil prices that, while low probability, would have an outsize impact on the global economy – a classic “fattening of the tail”. I look at monthly and aggregate data to smooth out daily fluctuations and avoid having us mistake the forest for the trees.

The data shows that in the 1980s, the most-cited oil price war, the average price of oil dropped from approximately $28/barrel in 1985 to a low of $11.58/barrel in July 1986 (US Energy Information Administration data for monthly average front month futures contract price). This would be analogous to a drop from $60/barrel to $25/barrel in 2014 prices, using the US Bureau of Labor Statistics CPI calculator. Prices subsequently rebounded almost 60% from that July 1986 low, ranging between $16/barrel and $20/barrel for the rest of the 1980s. (There were a few months in that 4 year timespan where the average dropped below $15/barrel, but I want to focus on the big picture in this article.) Inflation-adjusted to 2014 price levels, oil prices ranged between $29/barrel and $37/barrel.

Then something dramatic happened. Between July 1990 and October 1990, prices nearly doubled from approximately $18.50/barrel to $36/barrel. You have probably deduced by now that this was when Iraq invaded Kuwait. For the next 3 years, $20/barrel went from being a ceiling for oil prices to being a floor. Subsequently, prices dropped in the rest of the 1990s until doubling and then tripling in the 2000s for reasons that are beyond the scope of this article.

Fast forward 25 years and we are again seemingly in the middle of a price war with no bottom in sight. This time, though, it may indeed be different. It would be foolish to assume the Russians do not remember the impact of the 1980s oil price collapse on the Soviet Union, then one of the largest producers in the world. At over 10 million barrels per day, Russia today rivals Saudi Arabia in terms of production, with each country representing approximately 10% of global supply. Iranian oil exports, which had only just begun to recover thanks to the loosening of sanctions, are now being hit by lower prices. At 2+ million bpd of exports, a $40/barrel drop in price means Iran is “losing” over $25 billion/year in badly-needed revenue. This is not small potatoes for a country whose GDP the World Bank estimated was only $366 billion in 2013.

Note that both Russia and Iran have shown a willingness to act unilaterally at great cost. From annexing Crimea to visibly increasing bomber patrols in Northern Europe and the US Gulf Coast, the Russians have proven they are no wilting flowers. Indeed, some would say they rely on European dependence on Russian natural gas to get their way. The Iranians have consistently refused to actually dismantle existing nuclear facilities. There has been a great deal of talk about talking, but centrifuges continue to spin.

It does not take a rocket scientist to deduce that any increase in geopolitical instability which increases the price of oil benefits Russia and Iran. It is worth pondering the implications of that statement. I am emphatically not stating that the two countries will act irresponsibly to raise the price of oil. I am just pointing out that, for both countries, lower oil prices may have subtly shifted their calculus and their thinking around the risk-reward of their actions.

We do not need to ascribe nefarious intentions to large oil producers to understand how low prices can have significant geopolitical impacts. Smaller producers such as Venezuela and Nigeria, battling social instability at home, are being hit hard too. As much as the two countries may seem removed from mainstream Western consciousness, the world does not need a new source of volatility in Latin America or increased volatility in a West African region already grappling with Islamic militancy. Lower oil revenues do not help the Nigerian army, guardians of millions of barrels per day of light sweet oil, to procure weapons and train troops to combat secessionists and Islamic militants.

Of course, prices may drop another $30/barrel. The broader point of this article is that lower oil prices have potentially “fattened the tail” by altering probabilities, risk-reward calculations and, as the global economy adjusts to lower prices, the impact of an increase in the price of oil from here. Wearing my trading and portfolio management hat, I personally would not buy oil futures or even outright buy long-dated calls. The probabilities, in my mind, are not high enough to justify the potential losses. But I have begun looking at low-cost, high-payoff options structures such as vertical call spreads and butterflies to see if they make sense as tail hedges in a potentially more geopolitically volatile world. Note that these are not trading recommendations in any way, shape or form. Just a way of articulating my thoughts.

So, is cheap oil too much of a good thing? In terms of raw numbers, it is a very good thing. In terms of fat tails, perhaps not.


By Jay Bajpai,

Category: Brent Crude

About Bramesh

Bramesh Bhandari has been actively trading the Indian Stock Markets since over 15+ Years. His primary strategies are his interpretations and applications of Gann And Astro Methodologies developed over the past decade.

One thought on “Cheap Oil: Too Much Of A Good Thing?


    Hi Bramesh i want to remind you that most of the crude oil is a natural resource available under ground like water so naturally we expect the price to be near to that of water at Rs 500 per tanker or Rs 25 per barrel plus over head safety precaution as oil is inflammable even at double the base price it will come to Rs 50 per barrel to this add another greed factor(as oil is non renewable ) even at 10 times it comes to Rs 500 per barrel , at today’s exchange rate it comes to $ 10 per barrel .It is evident OPEC countries where exploiting emerging countries like INDIA ,so India should initiate steps in the world economic forums for reversal of excess paid .


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