FASTEN your seat belts. Turbulence is ahead of us. Oil prices have plunged 50% within five months, something which was unthinkable only a few months ago. Financial markets are reeling. Lo and behold, the global economy is now grappling with another round of uncertainty.

But hold on — some economists are saying that this could actually be the sweet spot for the global economy. In fact, if you talk to laymen, they can’t be easily convinced that paying less for their petrol is bad. And who could blame them?

Of course, we know that the impact of lower oil prices will differ from country to country. Generally, for energy-importing countries, cheaper oil is good news: import prices will be lower and hence, producer and consumer prices will decline, benefiting consumers. And consumers who can now save more will splurge on other goods. As a result, companies’ profits will rise, leading to higher investments and hiring. This will undoubtedly be positive for the economy.

Such a scenario is unfolding in the US as gasoline prices dropped below US$2.50 per gallon, the lowest since May 2009, fuelling stronger consumer spending, which accounts for roughly two-thirds of the economy. As a result, growth is now projected to strengthen to circa 3% in the next one year, according to the US Federal Reserve. And a stronger US economy is precisely what other countries are longing for at this juncture.

The International Monetary Fund’s (IMF) managing director Christine Lagarde was also reported to suggest that on a “net-net” basis, the oil price drop will be “good” for the global economy. According to her, a 30% decline would add almost 1% to the growth of advanced economies. Another economist from Oxford Economics also argued that lower oil prices tend to “redistribute income to those who have higher propensity to consume” (generally the lower-income groups) and encourage investments which would be positive for most economies.

Adding to the positives: for some economies, declining oil prices would open up opportunities to reduce or eliminate fuel subsidies altogether, hence reducing the burden on governments’ financial positions. And we all know that a healthier financial position will be a plus point for any economy and from a sovereign rating perspective, it will also be credit positive.

For some oil-exporting countries, on the other hand, the recent steep drop in oil prices raises the spectre of events akin to the 1998 rouble crisis. Government revenue shrinks and spending plans, which were initially based on higher projected oil prices, have now been shelved. Russia is a good example of this — its export sector has been hit by plummeting oil prices and hence, its economy is now at the doorstep of a recession. The significant plunge in its currency (the rouble) by nearly 50% on a year-to-date basis has led to speculation that the country may need to restrict capital movements in the near term.

Directly or indirectly, other commodity prices have also dropped quite significantly from their highs of 2014: silver fell approximately 26%, copper 15%, gold 13%, palm oil 25% and so on. For commodity-exporting countries, lower prices mean lower export revenue, which in turn leads to lower corporate profits. This will subsequently entail lower future investments and slower hiring.

In the broader picture, stock markets will tank and governments would have lower revenues to finance their expenditures. For countries that are already experiencing budget deficits, the negative gap is expected to widen. Those that already have unfavourable trade positions (current account deficits) will likely see their currencies battered due to the “twin deficit” situation. All of these would increase scrutiny by rating agencies.  All-around bad news, indeed.

But as always, financial markets tend to overshoot. The herd mentality normally causes over-optimism and over-pessimism. Greed and fear lead to exponential moves in the prices of currencies, commodities, equities and so on. The current situation is not an exception.

Common sense tells us that exponential increases in oil prices in the past 10 years were hard to rationalise. Of course, it is easy to say that in retrospect, but financial markets are never rational in the first place. Fundamentally, even after 2011, when economic malaise struck the eurozone and China was struggling to sustain its growth above 7.5% per annum, oil prices remained close to or above US$100 per barrel.

Technically, if one were to draw a long-term trend line for oil prices since the 1990s, he or she would see prices constantly breaking the upper bands of one and two standard deviations above their means in some years. Yet, the market continued to ascend.

Arguably, global supply of oil has increased while demand has subsided. Technologically advanced economies inundate the global oil market through their shale production, while global demand has slowed following weaker prospects of the major economies of the eurozone, China and Japan. But then again, the current oil price level once again looks disconnected from global economic conditions, only this time they are on the downside.

For instance, China’s economic growth of 7% to 7.5% is more consistent with oil prices of US$65 to US$75 per barrel, going by the historical statistical correlation since 2008. And the stronger US economic locomotive which may prevent emerging markets from falling off the cliff means the current oil market is dominated by extreme fear factors.

Admittedly, no one can precisely foresee where things are heading when it comes to predicting financial markets. Price overshootings are a frequent phenomenon. Fear and greed will constantly drive prices way above or below their fundamental levels — if fundamentals exist in the first place.

The famous phrase says it all: if prices look too high to be true, they are probably too high. And in the case of oil prices, the opposite could be true at this juncture. Now, draw a long-term trend line and notice that oil prices below US$60 per barrel are actually below two standard deviations from their means. Is this sustainable?

I am personally struggling to find good reasons to support this at this juncture. But then again, only time will tell.

Nor Zahidi Alias is chief economist at Malaysian Rating Corp Bhd

This article first appeared in Forum, The Edge Malaysia Weekly, on January  05 - 11, 2014.

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