The physicist Niels Bohr once quipped that prediction was very difficult ‘especially if it’s about the future’. His scepticism applies doubly to attempts to forecast the oil price. The ultimate in chaotic systems, the crude market can be swayed by disruptions in any one of a dozen large oil-producing nations, shifts in demand in rich energy-consuming countries or simply a change in sentiment among speculators.
While short-term swings in the oil price won’t get any easier to anticipate, several historic trends have recently converged that seem to promise cheaper oil for the foreseeable future. The first – new drilling techniques that have unlocked previously inaccessible oil deposits – has been exhaustively commented on for several years now. More recently, however, the OPEC cartel of oil-exporting nations appears to have abandoned its long-standing mission of promoting high and stable prices. In a landmark meeting in November 2014, Saudi Arabia – OPEC’s biggest producer – refused to cut output despite a sharp fall in the price of Brent crude, a benchmark for oil prices globally.
‘OPEC is broken,’ says Tom Biracree, an energy analyst at IHS, a consultancy. ‘Combine this with the extra supply from shale oil, and the entire energy game has changed. The upshot is we are unlikely to see a sustained return to US$100 a barrel oil any time soon.’ This has far-reaching implications for the global economy. It affects growth rates, inflation, financial markets and even government policy.
Let’s start with growth. All else being equal, the price of oil should have no impact on economic growth. After all, every dollar gained by oil consumers in lower prices is a dollar lost by the drillers. In addition, modern service economies have become less reliant on crude oil. The US, for example, now uses 58% less energy to produce each dollar of GDP than in 1950, according to government data.
Nevertheless, the crude oil price remains a powerful influence on economic growth. Its sway stems from the different patterns of consumption and savings between oil-consuming and oil-producing nations. The elites who control much of the wealth in oil-rich states tend not to adjust their spending significantly whether oil prices go up or down. The tsunami of extra cash that floods into oil producers during periods of pricey oil is often hoarded in sovereign wealth funds. By contrast, oil consumers typically spend about half their windfall from cheaper oil over the course of a few years, says Andrew Kenningham, a global analyst at Capital Economics. ‘This produces a strong multiplier effect,’ he adds.
The sums involved are significant. At US$100 a barrel, the average price in 2014, the world’s oil consumers spend around US$3.3 trillion on crude – about 4% of world GDP. As a result, a fall to $60, which was the price in June, reduces the global oil bill to US$2 trillion (roughly 2.5% of world GDP), transferring US$1.2 trillion from producers to consumers. Capital Economics calculates that each US$10 per barrel fall in price should boost global GDP by around 0.2%. If the US$60 a barrel price persists (indeed, it fell to US$43 in August), then cheaper oil could add about 0.8% a year to global growth. With world GDP growing by just 2.8% in 2014, that’s a sizeable lift.
The gains are naturally skewed towards those nations that have the largest net imports relative to the size of their economy. Many of the biggest winners are in Asia, says Mark Zandi, chief economist at Moody’s, the credit rating agency. India, which has limited domestic energy production but an energy-hungry economy, is a good example. A US$40 fall in the price of oil, Moody’s calculates, adds a full percentage point to the country’s rate of economic growth.
There are other benefits too for nations like India. Cheaper oil has helped bring down its worryingly high inflation rate, allowing the central bank to cut interest rates. ‘Cheaper borrowing for businesses and consumers should add a secondary fillip to growth,’ says Zandi.
Japan and the eurozone – both economies with near zero domestic oil production – also fare particularly well. The eurozone, for example, generates enough oil within its own borders to supply only about 3% of its total consumption. ‘At least part of the credit for the recent revival in eurozone growth can be attributed to the turn in the oil price,’ says Zandi. ‘The single-currency zone badly needed a helping hand.’
There are also notable sectoral winners. One unlikely gainer is farming. Agriculture is roughly five times more energy-intensive than manufacturing, according to the World Bank, partly on account of the reliance of farmers on modern agricultural machinery and fossil fuel-based fertilisers. Other winners include airlines, freight companies and car makers.
Useful as such short-term boosts may be, many economists are hoping that longer-term structural improvements will also flow through coming years. Currently governments around the world spend around US$550bn on subsidies for fossil fuels, according to the International Energy Agency, including costly taxpayer support to lower the price of petrol for consumers. ‘This has been a huge burden on budgets, pushing up deficits around the world and reducing the sums available for productivity-enhancing spending on infrastructure or education,’ says Gabriel Sterne, chief analyst at Oxford Economics.
Such subsidies have been politically difficult to withdraw, since they raise the price of driving for millions of car-owners. ‘A fall in the oil price makes it possible to wean the public off this support without a painful and conspicuous increase in the cost of filling up their cars,’ Sterne adds. Indonesia has already seized the opportunity and scrapped subsidies. If more nations do so, argues Sterne, the economic benefits would last for decades, even if the price of oil eventually rises up beyond US$100 a barrel again. And that is not counting the ecological benefits as consumers use less petrol.
Naturally, there are also plenty of losers from falling oil. The main question for economists is whether the pain inflicted on a smaller number of petro-states will end up disrupting financial markets and the global economy.
The reassuring answer is: almost certainly not. For a start, many of the most important producers are financially well prepared. Take Saudi Arabia, the world’s largest oil exporter. With output of around 10 million barrels a day – about 11% of the global total – the country is about US$35bn a year worse off for every US$10 fall in the price of Brent. Yet the Saudi government has accumulated net foreign assets of around US$737bn (2.8 trillion riyals) as of August 2014. That’s equivalent to a full three years of government spending. Saudis could cope with years of low oil prices before being forced to cut back.
‘The kingdom was extremely well prepared for this fall,’ says Biracree. ‘To some extent they even chose to allow oil prices to go lower by refusing to cut production at the November 2014 and June 2015 OPEC meetings. Had it wished to, Saudi Arabia could almost certainly have kept the price higher.’
Opinions differ on why the world’s largest oil state would want cheaper crude. Some have speculated that Saudi is looking to hit strategic rivals such as Iran and Russia, for which lower prices are far more painful. It is also possible that the main motive is to reduce the appeal of more efficient vehicles, such as hybrids and electric cars, and so prolong the dominance of oil. Finally, Saudi officials may have concluded that OPEC is no longer capable of the unity required to make coordinated production cuts.
‘With so many fiscally overextended members, like Venezuela or Nigeria, you had a situation in which Saudi Arabia had to bear the burden of any output cuts almost alone,’ says Biracree. ‘The nation’s leaders may have finally decided that cutting their output so that Venezuela could enjoy higher revenue was not a good deal for them.’
A handful of other major oil producers are also in a position to tolerate lower prices almost indefinitely without slashing spending. Abu Dhabi and Norway have used past oil profits to build up two of the largest sovereign wealth funds in the world. Norway’s US$916bn fund is now worth more than twice the nation’s annual GDP, on track for about US$420bn in 2015, according to the International Monetary Fund. The fund’s investment returns in the first quarter of 2015 were larger than government spending.
Yet some nations could be pushed over the cliff by the plunge in oil prices. The most obvious example is Venezuela, which gets over 95% of its hard currency revenue from oil. After years of profligate fiscal spending, the country needs to sell oil at US$90 a barrel just to balance the government budget, according to Deutsche Bank. With the current oil price a third below this, the nation’s foreign currency reserves are dwindling fast and credit default swaps are pricing in 90% risk that Venezuela will default on its debts over the next five years.
‘A day of reckoning is fast approaching for Venezuela and a debt default looks likely,’ says Win Thin, an emerging markets analyst at Brown Brothers in New York. ‘But most investors gave up on Venezuela a long time ago, so even a total collapse of the country is not going to disturb emerging markets more generally.’
A crisis in Russia, another nation with an unhealthy reliance on oil exports, is a bigger worry for investors. The economy is on track to contract by about 2.7% this year, according to the World Bank, based on a forecast average Brent price of US$58 for 2015 and the continuation of US and EU sanctions. Still, here again, international exposure to Russia is considered containable by most analysts.
The bottom line is that while cheaper oil will cause acute problems for a handful of oil producers who failed to stockpile funds during the good years, the overall impact on the global economy should be extremely benign.
‘So far the rewards of lower oil prices have been relatively slow to come through,’ says Zandi. ‘That’s possibly because some consumers fear that the price reduction won’t last. But it is fairly clear that this is no mere blip. As it becomes clear that cheap oil is here, the full economic benefits will become more obvious.’
Christopher Fitzgerald and Fernando Florez, journalists
This article first appeared in the Singapore edition of Accounting and Business magazine, in November 2015.