In June of this year one of the economy’s most important commodities, oil, entered a downtrend. It currently trades at a five year low and there is still no sign of a trend reversal. How did the oil price plunge this deep? And what kind of economic implications does this have? In my analysis I will address these questions.
History of oil prices
Let us start with a short overview of the history of oil prices to put the recent drop in perspective. Until 1973, the oil price was controlled by the importing countries and oil prices were as low as 2.50 to 3.50 dollar per barrel, which is equal to 10 to 15 dollar in today’s money.
However, when the Organization of Petroleum Exporting Countries (OPEC) decided to impose an oil embargo on the Western countries which supported Israel in the Yom Kippur War in 1973, prices skyrocketed and the OPEC realized its power. Nevertheless, because of the high price level, supply increased and consumers economized. This caused prices to decrease to around 35 dollar per barrel and it has fluctuated around this price for almost thirty years.
After 2000 the low-cost oilfields became depleted and oil had to be extracted from more costly fields which caused a drop in investment in new supply. At the same time, the economic growth in the emerging markets, China in particular, caused the world demand for oil to grow tremendously. These two factors together made the oil prices soar to over 140 dollars per barrel in the period just before the credit crisis. The chart below shows the net change in oil consumption per region.
During the credit crisis, however, the oil price fell sharply from 146 dollar in June 2008 to 44 dollar in February 2009. It quickly recovered to a range around 110 dollar per barrel and stayed there until June of this year when prices started to fall severely. Why did the prices fall so suddenly and what does a permanent low level of oil price mean for the different actors in the economy? In the remainder of this article I will try to answer these questions.
Why did oil prices collapse?
There are several reasons for the recent drop in oil prices, which I will explain below.
Supply: High oil prices have made previously unattractive oil fields profitable, and the US output grew with approximately 50 % in the last five years to 13.5 million barrels a day. While one would normally expect that this would cause the oil price to drop, it stayed more or less stable around 110 dollars per barrel. The lack of a strong decrease in price was due to the collapse in supply from Nigeria, Syria, Libya, Sudan and Iran, as is shown in the chart below.
However, the output from those countries has recently recovered somewhat towards their pre-crisis levels. The largest increase came from Libya, which came from 0.2 million barrels per day in April to 0.8 million barrels today. Together, Nigeria and Angola also account for an increase of 0.5 million barrels daily. With this sudden increase of supply the oil prices started to tumble into a free fall to around 80 dollars and fell even further after OPEC decided at its latest meeting that it would not cut back its supply in order to raise the prices again.
Demand: The rising supply is not the only factor that puts downward pressure on oil prices. The oil prices were also affected by disappointing growth figures from China and Europe. The graph below plots the oil prices against a global (ex US) growth surprise index calculated by UBS and shows a strong correlation between these two factors.
Another culprit of the collapse in oil prices is the strong dollar. Since oil is priced in dollars, an appreciation of the USD against other currencies will result, ceteris paribus, in a decrease in the oil price measured in dollars. The figure below confirms this inverse correlation between the value of the USD and the price of oil (Brent crude).
What does a low oil price mean for the economy?
We now know why current oil prices are at a lower level than before and how they arrived there, but what does this mean for the economy? First of all, lower oil prices lead to lower inflation figures and thus improves real wages in oil consuming countries. This might convince central bankers to use a more expansionary policy to boost inflation which in turn can boost economic growth. How much the inflation will be affected by the low oil prices depends on the relative weight of oil in the consumer price basket of the country. The graph below shows the inflationary effects of a permanent 15 dollar retreat in oil prices.
Let us take a look at how much several different countries gain or lose from the current low oil prices.
The big winners are clearly the countries with a high dependency on imported oil, but the degree of benefit differs between them. The countries with a high current account deficit caused by their dependency on imported oil are amongst the greatest beneficiaries, examples being Thailand, South Africa, Turkey, India and Poland.
Other beneficiaries are the countries in the Euro area, because of their central banks’ guide lines. The ECB targets headline inflation which includes energy prices. This means that the plummeting oil price, with its disinflationary effects, adds another stimulus for the ECB to loosen its monetary policy. This policy will spur economic growth in the Euro area and also weaken the Euro, which in turn helps European companies to export at a cheaper rate.
In the US the effect will be fairly positive. Obviously, the tumbling oil prices will cause a loss in jobs in the American oil exploration sector, but this will be more than offset by the positive effects. US citizens regard a decrease in energy prices as they would experience a tax reduction. Simply put, this implies that US citizens will spend more money and hereby boost customer discretionary companies. This will eventually result in more jobs and higher stock prices in this industry.
The losers are of course the oil producing countries, although some are hurt more than others. The countries which suffer the least are the ones that are running a high current account surplus and have a large stock of international reserves. This comes down to the members of the Gulf Cooperation Council (GCC) which consists of Saudi Arabia, The United Arab Emirates, Qatar, Kuwait, Bahrain and Oman. The table below shows the prices at which the fiscal budget of the countries breaks even.
One might wonder how a country from this area, which produces a barrel of oil far under 10 dollars, needs such a high price to balance its fiscal budget. The reason for this is the extreme increase of public spending of Gulf States after the oil prices soared in 2003. If the oil prices remain this low, they might have to cut back their expenses or start levying higher taxes (currently the tax burden in the GCC countries is less than 2% of GDP on average). The graph below shows the increase in public spending of the GCC countries in billions of dollars.
Finally, we arrive at the countries that are hit the worst, the ones that are dependent on the exportation of oil and have an unstable balance of payments situation. Examples of these countries are Venezuela, Colombia and of course Russia. The latter two already see their currency slipping away tremendously and all of them will definitely see their GDP deteriorate as long as the oil price stays this low or plunges even lower.
The scatter plot below plots the dependency on oil import/export and the current account balance from the most important countries in the world. With the help of this chart one can determine if a decreasing oil price will have a positive or negative effect, depending on whether the country is a net importer or exporter. The lower the dot, the more extreme this effect will be.
We know which countries suffer and which countries thrive in a bearish oil market, but what does it mean for the world economy? Assuming that the marginal propensity to consume (the aggregate raise in income that a customer spends on the consumption of goods and services) is higher in oil consuming countries than in oil producing countries, we can expect a net growth in the world economy, given that GDP is transferred from the latter to the first type.
The graph below shows how the low oil price redistributes GDP from oil producing countries to oil consuming countries after a permanent 15 USD decline (per barrel).
To conclude, we see that the recent fall in oil prices was caused by a combination of increasing supply, expectations of stagnation in demand and a stronger dollar. This low oil price causes a transfer of GDP from oil producing countries to oil consuming countries and puts a downward pressure on the inflation of oil dependent countries which might result in a looser monetary policy in these countries.
As long as the OPEC stays divided and geopolitical events cause no supply interruptions there is no reason to suspect the oil price to return to previous highs in the near future. However, this remains an interesting topic for further analysis.
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As a Msc student Finance and member of the Risk Investment Team, Jan follows the financial markets on a daily basis.