hat does the decline in oil prices mean for the world economy? The answer depends on why it has happened and how long it might last. But overall it should be helpful, albeit with caveats. Particularly important might be the impact on net oil-exporting countries. Among vulnerable producers are regimes that one would dearly like to see weakened, Vladimir Putin’s Russia foremost among them. But even here the silver lining has a cloud. As Kirill Rogov of Moscow’s Gaidar Institute has noted, lower oil prices might exacerbate Mr Putin’s revanchism.
Between late June and the beginning of this month, the price of crude oil fell by 38 per cent. This is a big decline. But a bigger one occurred between the spring of 1985 and the summer of 1986. The sharp fall in the early to mid-1980s – not coincidentally, the event that preceded the collapse of the Soviet Union – was caused by two developments: the reduction in the energy intensity of consumption and production triggered by the two “oil shocks” of the 1970s; and the emergence of significant production in non-Opec countries, such as Mexico and the UK (see chart).
The story this time is not so different, particularly on the supply side. According to the International Energy Agency’s latest World Energy Outlook , supply of non-Opec oil and natural gas liquids might rise from 50.5m barrels a day (mbd) in 2013 to 56.1mbd in 2020. This would raise the share of non-Opec producers in global production from 58 per cent to 60 per cent. As much as 64 per cent of this increase is forecast to come from North America. Behind the rise in North American production is unconventional oil – so-called “tight oil” – in the US and oil sands in Canada. Meanwhile, Opec production is forecast to remain roughly constant.
The revolutionary developments in unconventional oil production have already made a substantial difference to production (see chart). US production of liquids has risen by 4mbd over the past four years. According to HSBC, US output is expected to rise by 1.4mbd this year. Libya’s output is also recovering. Finally, unexpected economic weakness in the eurozone, Japan and China has cut estimates of global demand by 0.5mbd this year. To sustain oil prices, Opec needed to cut output by about 1mbd. But it – or, more precisely, Saudi Arabia – has refused to do so. This has triggered the recent fall in prices.
Will these low prices last, or might they go even lower? I am not foolhardy enough to forecast oil prices: the price elasticities are so low and the margins between supply and demand so fine that it is all too easy to forecast wrongly. The case that the decline will prove temporary is that Saudi Arabia’s desire to cripple production of unconventional oil, which demands a high level of capital expenditure, will swiftly succeed. Moreover, the lower oil prices, a hoped-for economic recovery and continuing rapid growth in emerging economies could boost demand for oil. In addition, argues HSBC, “global spare capacity is still very tight by historical standards and largely concentrated in Saudi Arabia”. Having made their point, the Saudis might yet cut production.
At this stage it seems unclear whether we are witnessing a lasting structural downshift in prices. But let us assume they last for quite a while. What would be the consequences? Here are six.
First, a $40 fall in the price of oil represents a shift of roughly $1.3tn (close to 2 per cent of world gross output) from producers to consumers annually. This is significant. Since, on balance, consumers are also more likely to spend quickly than producers, this should generate a modest boost to world demand.
Second, the fall in energy prices will lower already-low headline inflation. This creates two offsetting risks. One is that it might entrench expectations of ultra-low inflation. An opposite risk is that it might encourage central banks to ignore threats of rising underlying inflation. On balance, the former is at present a greater threat than the latter.
Third, the fall in energy prices will boost the profitability of energy intensive production. At the same time, it is cutting the profits and capital spending of oil producers. It could create significant bankruptcy risks in the energy sector, particularly among the more highly leveraged oil producers. How far that would also damage lenders is unclear.
Fourth, the fall in prices will redistribute income from net-exporting countries to net importers. Among the latter are the eurozone, Japan, China and India. The US is now a net exporter. But the important net exporters are countries that are heavily dependent on these revenues. Among them are Iran, Russia and Venezuela. It could not happen to nicer regimes! But there is also danger when despots are in a corner.
Fifth, the fall in energy prices will create shifts in asset prices. The exchange rates of energy-producing countries will be under downward pressure, already to be seen in the sharp fall in the Russian rouble. Shares in companies that benefit from lower oil prices, directly or indirectly, will rise. This might create new stock market bubbles.
Finally, falling oil prices threaten to make economies more carbon intensive and less energy efficient. But they also give an opportunity to raise taxes on oil or at least cut wasteful subsidies to consumption permanently. It is an opportunity that any sensible government would seize. Needless to say, the supply of such governments is rather small.
Much uncertainty remains over how low prices will go, and for how long. But to the extent that they reflect strong supply rather than reduced demand, they offer a welcome boost to the world economy. They also represent a welcome transfer of income from unattractive petro-despotisms. It is hard not to cheer that, even if the opportunity for lower subsidies and higher taxes will yet again be thrown away.
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