If you pay attention to financial news, you’ve probably noticed by now the sharp decrease in oil prices over the last few months. Investors are panicking. Should you panic too? This isn’t the first time that oil prices have dropped dramatically, and it won’t be the last time either.

Source: http://www.nasdaq.com/markets/crude-oil.aspx

The last significant drop in oil prices happened during the start of the United States’ financial crisis of 2007/2008. Near the end of 2008, when the crisis was coming to fruition, oil prices plummeted over a 6-8 months period. The price peaked at $140 per barrel and dropped to around $42 per barrel. This was major and sudden.

Different Circumstances

The current drop in oil prices isn’t quite the same as the last sudden drop in prices. The most obvious difference is that there currently isn’t a financial collapse on the horizon. Oil prices increased rapidly in the early stages of the financial crisis, but once oil countries realized the true impact the crisis would have, they made significant changes in production and pricing. Demand in oil dropped across the globe as the financial panic set in. Production couldn’t be slowed fast enough. Thus there was a drop in prices.

Although the current demand for oil across the globe is slowing, the rate at which it is slowing is nowhere near 2007/2008 levels. There’s another culprit to blame: US shale extraction. The US energy sector is booming, or at least it was. New technology developed by the United States has allowed energy companies to extract natural gas from deep inside the earth. This new energy in the marketplace has created excess supply. This extra supply combined with the marginally slower demand for energy has put oil-producing countries in an awkward position.

OPEC, at the behest of Saudi Arabia, has decided not to slow down production of oil. The supply has continued to increase while the demand is rather stagnant. Therefore, oil prices have dropped significantly. Some have speculated that this was an intentional move by OPEC to damage US shale production. This process is known as “fracking” and is more expensive and has smaller profit margins than regular oil production.

By forcing the price of oil to decrease, many US energy companies can no longer afford to use the fracking process. Regardless of the motivations of OPEC, it is clear that oil prices will continue to stay sub-$100 per barrel for some time to come.

How this affects investments globally

Wall St. has reacted quite negatively to falling oil prices. The energy sectors in many countries are massive. Some of the largest companies in the US are energy companies. If you are heavily invested in energy sector index funds, blue chip stocks, derivatives or anything else you may want to hold off on further purchases. You may also want to consider reducing your position.

As we stated previously, this situation is different. Oil prices didn’t fall from as high of a peak as the 2008 situation. However, they also aren’t increasing at the same rate either. Profits in the energy sector are dropping and will stay lower for the foreseeable future. This will directly affect any of your investments in the energy sector. The US isn’t the only country to be affected by a drop in oil prices.

Countries such as Saudi Arabia, Russia, Argentina and Malaysia rely heavily on their oil production for revenue and GDP growth. These are the countries that will be hit the hardest. Malaysia, for example, has taken a significant hit in revenue. Revenue is down and as a byproduct investors aren’t as confident in the Malaysian market. The Malaysian Ringgit (MYR) has dropped 10% relative to the US Dollar (USD). It should be noted that the USD is rather strong right now. The MYR 10% relative drop in value against the USD isn’t completely because of oil prices.

The situation is Malaysia is difficult to gauge. Although a 10% drop in value for the MYR isn’t enough to cause a panic, there are other factors that should be taken into consideration. Malaysia faces a unique situation in South East Asia. We have higher than normal household and national debt. Our bond market also relies heavily on foreign investment, around 40%. If investors don’t feel confident in the Malaysian market, the country may see a significant slowdown.

However, the government of Malaysia only decreased their GDP forecast by 0.5%, from 5-6% to 4.5-5.5%. This isn’t a major change. It’s likely that other sectors of the Malaysian economy will benefit from a devalued currency and lower oil prices. Smart moves by Malaysian investors and the government will dictate how much of a negative impact lower oil prices will have on Malaysia.

What this means for investors

There are two ways to read a drop in oil prices from an investing perspective. The first is to understand that there is a general slowdown in the global economy. This is why the demand in oil is dropping. The main factors for the global slowdown are shaky emerging markets, a Chinese slowdown, stagnant Eurozone, and political tensions in the Mid East and Russia. These are areas that should investors should be extra careful. The second factor to take into consideration is that lower oil prices may help other industries such as shipping and manufacturing.

As we stated earlier, energy sector investments should be cautious. Be vigilant in your investments and pay attention to oil prices and oil company revenue. Some investment experts claim oil prices will quickly return to normalcy. However, there is significant evidence to suggest that oil prices are not yet done falling. There is also prediction that oil prices will not recover at the previous rate. Look for industries that are strong and will benefit from lower oil prices. Diversify your portfolio to accommodate the changing global economy.


Personal finance author and trainer

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