Don’t panic: what you need to know about oil price volatility

Volatility in the oil and gas markets is not being matched in the wider indexes. Flickr/arbyreed, CC BY

Financial markets are certainly experiencing considerable turbulence at present, with a six year low in oil prices weighing on international exchanges and the value of Australia’s energy industry falling around 25% since September 2014.

How do we deal with this?

Commentators often focus on volatility in financial markets and the energy sector has been singled out of late, but volatility is a natural part of financial markets. Finance theory tells us as long as investors are well diversified, they will be compensated for the risk that cannot be diversified away and what is currently happening in the energy equity market is a good example of this in action.

It is rare that news reaching the market is all bad, even for one industry. Yet, the energy sector has seen little good news over the last few months, with oil and gas producers having a hard time of it as highlighted by the fall in the S&P ASX 200 Energy index, particularly from the end of May 2014 to early January 2015.

Yahoo Finance

If we calculate rates of return for the S&P ASX 200 energy index we get a sense of the changes in return volatility in this sector.

The returns reported in Figure 2 for the extended period from 30 March 2013 to 9 January 2015 do show increased volatility, particularly since November 2014,with dramatic rises and falls in index value.

But this is not the only period where volatility is evident in the market. Indeed, the market went through considerable volatility in the period from March 2013 to July 2013, less than two years ago.

Calculated from the index values supplied by Yahoo Finance

Should we be worried?

Yes, the energy sector has been hit hard by the recent falls in crude oil prices - but we should ask this: is this volatility widespread? Figure 3, which shows the daily returns on the Australian Securities Exchange from the end of March 2013 to the present shows little change in Australian equity market volatility more generally.

Calculated from the index values supplied by Yahoo Finance

The distribution of returns in Figure 3 is fairly uniform over the period and this tends to highlight the reason that finance specialists recommend diversification as a primary tool in investment. While the energy sector has been subject to considerable volatility, the market as a whole is little affected by the rather idiosyncratic events that have taken place in this industry. It appears movements elsewhere in the Australian equity market have cancelled out the energy industry woes. This observation is important to investors. Indeed, careful analysis of this diversification effect provides one of the reasons that Markowitz, Miller and Sharpe received their Nobel prizes in 1990.

Winners and losers

There is no doubt the current events affecting the energy industry will have a profound impact on the state of Western Australia. The economy in this state is already in shock from the recent fall in iron ore prices and the fall in oil and gas prices will not help the state government manage its budget.

Queensland in an important gas producer and the recent falls in crude oil prices will also have an impact on LNG prices. ( Eventually, Queensland Government royalty takings from gas production will fall and this could be of some concern to Queensland politicians with the coming election.

Yet, these same price falls will help the other industries in Australia. The primary industry depends on petrol, diesel and fertilisers which are produced from oil and gas and so it is expected that the primary industries will become more profitable with the fall in oil and gas prices. The fall in iron ore prices may also eventually lead to cheaper steel which affects the cost to farmers of fencing.

The oil and gas price falls will have a direct impact on fuel costs across the entire economy - consumers are already enjoying cheaper fuel - and the other impact will be decreasing costs on a wide range of products and services.

This is not the only effect of the fall in the resource sector (mining and oil and gas). It’s argued that the Australian dollar is a commodity currency and indeed, the Australian dollar has devalued with the fall in iron ore and oil and gas prices, falling more than 15% (10%) over the last six months (Figure 4). This devaluation will have a direct impact on exporters, including the miners. Exporters will be in a much better position now than they were just six months ago.

Reserve Bank of Australia (F11.1 Exchange rates)

Probably our most important exporters are the mining companies and primary producers. Both these groups gain from the devaluation of the Australian dollar. This will tend to lessen the effect of falling commodity prices that mining companies face at present. Mining companies export their output at world prices and these are expressed in US dollars. So, if the Australian dollar devalues with respect to the US dollar then the Australian dollar price of exported goods rises, thus dampening the effect of the fall in the world price of commodities.

The devaluation of the Australian dollar will also improve the marketability of our primary products. These include meat, wheat, dairy products and wool. Other important benefactors include service providers and our education industry.

Finally, interest rates are also lower than a year ago and this will tend to decrease the cost of investment. As a result, exporters who choose to increase productive capacity may be able to borrow more cheaply than they could 12 months ago.

All in all, while the resource sector is struggling it is important to keep an eye on what is happening in the Australian economy more generally. There is good reason for concern, particularly in Western Australia and Queensland, but there is also good reason to take a more positive view about the Australian economy.

A pessimist might note the possible impact of fire and drought on primary production over the long hot summer to come and the possibility of further disruption in the regulation of the education and services sector with recent government initiatives. An optimist might take the alternate approach and agree to wait and see what the future brings.