The consensus view is that lower oil prices are likely to assist the global economy. Quantitative greasing will augment quantitative easing, supporting economic activity.
A US$40 fall in oil prices equates to an income transfer of around US$1.3 trillion (around 2 percent of global GDP) from oil producers to oil consumers. A sustained 10 percent cut in the oil price is generally assumed to increase global GDP by 0.20 percent per annum. The 40 percent fall should boost global growth by 0.80 percent.
Lower oil prices increase disposable income. The average US motorist spends around US$3,000 per annum on gasoline. US households may save around US$500 to US$600 a year. If this money is spent then it will boost growth. There are also indirect channels such as transport costs. It also affects agriculture, which is four to five times as energy intensive as manufacturing. This includes fertilisers which use petroleum feedstock, electricity for pumping water for irrigation and refrigeration and transport costs to move output to markets.
The favourable effect of low oil prices is based on differences in the marginal propensity to consume. The essential assumption is that a lower price increases GDP by shifting income from producers to consumers, who are more likely to spend.
Historically, this relied on oil producers being thinly populated desert Sheikhdoms with limited ability to spend oil incomes. The position currently is more complex. Many oil producers are now fiscally profligate, using strong oil revenues to finance ambitious public spending programs or heavily subsidise domestic energy costs. Lower oil prices will force these governments to curtail programs and subsidies or increase debt, which might reduce the positive effects on growth.
The domestic cost of energy is affected by currency factors. A stronger dollar may offset some of the benefit of lower oil prices, reducing savings. A factor frequently missed is that in local currency terms oil was still trading at near record highs until very recently, especially in emerging markets.
Another complicating factor is whether the lower oil prices flow through to consumers. A number of countries, especially in the Middle East and emerging markets, subsidies energy consumption, by an estimated US$550 billion. These subsidies frequently benefit politically influential middle classes rather than the poor. In theory, lower prices reduce the cost of the subsidy to say US$400 billion. A number of governments, such as Indonesia and India, have taken the opportunity presented by low prices to reduce fuel subsidies. While positive for public finances and economic efficiency, the diversion of the benefits from consumers to the government is contractionary, reducing the effect on growth.
Even where the benefits flows through to consumers, it is unclear whether the consumption multipliers assumed now hold. A significant overhang of debt, employment uncertainty and weak income growth may result in the transfer being saved or applied to reducing borrowings, reducing the boost to consumption and growth.
Low oil prices reduce investment in energy exploration, development and production. One estimate puts the decrease in investment spending as a result of the fall in prices at almost US$1 trillion. This entails the deferral or cancellation of deep water, arctic oil, tar sands and shale projects as well as further investment in mature fields such as the North Sea projects, which require high prices to be economically viable. Oil producers are already also reducing costs, including renegotiating contracts with oil services groups. The lower spending levels will adversely affect activity and growth.
The overall effect on individual economies is uncertain. The US is simultaneously a large consumer, large importer and a significant producer of oil. Lower oil prices will boost economy activity marginally but a slowdown in energy investment and a stronger dollar may substantially offset any benefit. China is a large importer but a significant producer, complicating its position.
Europe and Japan as large net energy importers should benefit. India should benefit as crude oil constitutes over 30 percent of total imports and around 70 percent of its current account deficit. Lower prices allowed the government to improve its own finances by cutting fuel subsidies, which cost around US$41 billion a year or 14 percent of public spending and 2.5 percent of GDP.
Lower energy costs must be balanced against the effects on the overall level of growth and especially deflationary fears that may be exacerbated by weak oil prices. In some developed countries, low oil prices are already impacting on public finances. It may also trigger instability in financial systems through complex chains of lending and investment.
The decline in oil revenues will affect producers significantly. Significant government spending by exporters and narrowly based economies necessitates a high oil price to balance budgets.
Saudi Arabia is highly dependent on oil, which contributes 45 percent of GDP and 80 percent of government revenues. Government spending constitutes over 30 percent of GDP, with significant welfare programs designed in part to keep citizens quiescent and counter religious and political unrest. As a large exporter the 40 percent fall in prices equates to a fall in revenues of over US$100 billion. It is now forecasting its largest budget deficit in history, around US$40 billion. But Saudi Arabia has financial reserves of over US$700 billion, which allows it to finance large deficits.
The position of other exporters is more complex. Russia is exposed to the combination of lower oil prices and Western sanctions following its actions in the Donbass region of Ukraine. Over the last decade, Russia has used strong oil revenues to drive economic growth and rising wages and living standards. Falling oil revenues now make it difficult to sustain government spending. A weaker Rouble, down more than 50 percent, has cushioned the decline in revenues. But it has also increased the cost of imported goods. Overall economic activity is slowing with a recession likely. High inflation and high interest rates, in part to defend the Rouble, is also affecting growth.
Russia has reserves of over US$400 billion, although the immediately accessible amount may be significantly lower. This should help buffer the economy against oil-price fluctuations. However, businesses and weak banks now require state financing support because of a lack of access to international funding due to Western sanctions. In addition, the Russian central bank has been forced to intervene in currency markets to support the Rouble. The increasing claims on currency reserves mean that Russia has limited flexibility to manage lower oil prices.
Iran, Venezuela and a number of West Africa oil exporters, such as Nigeria, also face challenges. Iran requires oil prices of over US$130 a barrel to finance its government spending, including inefficient subsidies. Like Russia, sanctions limit ability to borrow internationally to finance revenue shortfalls. Venezuela, where oil constitutes 96 per cent of export revenues, needs oil prices of around US$120. Malaysia’ state owned oil company Petronas, which contributes around one-third government revenues, has announced that it will reduce its annual dividend to the state substantially if oil prices stay below US$70 per barrel.
With oil taxes and royalties represent nearly 90 percent of revenues, Alaska has been forced to halt hiring new employees, signing new contracts and committing any new spending. US states such as Texas, Pennsylvania, North Dakota, Colorado, West Virginia, Wyoming, Oklahoma and Montana face similar problems from lower government revenues and deferral of new investment in oil and shale production. The effects of the slowdown is exacerbated by the fact many of the better paying jobs created in recent years have been in the energy sector offsetting the growth in minimum wage service sector employment.
Budgetary, economic and debt problems increase political risks. The risk is heightened by the fact that many oil producers are ruled by autocratic and authoritarian regimes, politically unstable or lack proper institutional frameworks for participative government. The sharp falls in oil prices in 1985/ 1986 were, in part, key factors in the collapse of the Soviet Union.
© 2015 Satyajit Das
Satyajit Das is a former banker and author of Extreme Money and Traders Guns & Money