UBS: Slippery slope

However, a severe and persistent oil price drop could be bad for equity markets if it forces sovereign wealth funds, mostly owned by oil producer countries, to liquidate assets to cover deteriorating public finances in those countries.

Remember the old days when rising oil prices were considered bad news? Nowadays, it seems, falling oil prices are bad news. Plummeting stock markets are going hand-in-hand with collapsing oil prices (the correlation with world equity indices is almost one since the Fed hiked rates in December). If you do not live in an oil-exporting country, this looks a bit odd. Surely cheaper gasoline and energy bills are good news?

It is a good question, but first take a step back and ask what we mean by the oil price. Like almost all commodities, the price of oil is quoted in USD. Yet the USA accounts for only a quarter of global oil consumption and about a fifth of production. And over the last year and a half the USD has strengthened by about a quarter against other currencies, which makes oil prices more expensive in those countries when you convert back to the local currency. The drop in oil prices far outweighs the currency move, but it is a mitigating circumstance.

If we want to know what the oil price looks like for consumers around the world, we can create a price index that weights the local currency price of oil by the share of global consumption of oil. This consumption-weighted oil price has fallen by 64% since June 2014, as compared to a 70% drop in the USD price (chart 1). We can do the same to see how producers are faring, by using production weights. This price for producers is surprisingly close to the consumption price, despite many producers being pegged to the USD. There are exceptions: thanks to the drop in the RUB, the local oil price in Russia has fallen by less than a third.

This currency differential swung the other way in preceding years. As the Fed embarked on quantitative easing the USD fell relative to other currencies, pushing the local currency price down in other countries relative to the US. Or to put it another way, the weighted oil price indices rose sharply in early 2014, so for them some of the decline was simply reversing the recent spike.

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