Oil in the 40s: Crude's falling price has several negative effects as well

Vivek Kaul January 14, 2015 07:40:23 IST
Oil in the 40s: Crude's falling price has several negative effects as well

The price of brent crude oil fell by 5.65% on 12 January , 2015 to close at $47.43 per barrel.

Many experts who follow oil closely have talked about how a fall in the price of oil will be beneficial for the world at large. The logic is straightforward.

Most countries do not produce all the oil that they consume. Hence, they need to import oil. A fall in the price of oil means that these countries will pay a lower price for oil and in turn petroleum products like petrol, diesel etc.,will become cheaper. This means that citizens of these countries will have more money to spend on other things, which, in turn, will benefit businesses.

There are various estimates about how much this benefit will amount to for oil consuming countries. As Niels Jensen writes in The Absolute Return Letter for November 2014, titled Snail Trail Vortex: “A $20-per-barrel drop in oil prices transfers $6-700 billion from oil producing nations to consumers worldwide or nearly 1% of world GDP. Assuming consumers will spend about half of that on consumption, which historically has been a fair assumption, the positive effect on GDP in consumer countries is c. 0.5%.”

Author Satyajit Das in a recent research note titled The Reverse Oil Shock makes a similar assessment, when he writes: “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 price of oil has fallen by around $60 per barrel since end of May 2014. Using the numbers provided by Jensen and Das, we can conclude that an income transfer of around $2 trillion will happen from oil producers to oil consumers. This money when spent by citizens of oil consuming countries will lead to economic growth. This is a straightforward conclusion that can be drawn from this data to the condition that governments of oil consuming countries pass on the benefits of low oil prices to their citizens.

Oil in the 40s Crudes falling price has several negative effects as well

Reuters image

But this hasn't happened everywhere in the world. As Das writes: “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.”

The Indian government has increased the excise duty on petrol and diesel thrice since October 2014, in order to shore up its revenues. There are several other negative effects of a low oil price. The world at large is still in the process of coming out of a huge debt binge and hence, will use the money saved from the low oil price to repay debt. As Das writes: “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.”

Further, with falling oil prices the amount of money being spent on “energy exploration, development and production,” will come down. “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,” writes Das.

This can't be good for energy security over the long term. A news report suggests that there has already been a drop of “almost 40% in new well permits issued across the United States in November.”

A major reason for a fall in oil prices has been the massive amount of shale oil being produced in the United States. Oil production in the United States has jumped by 4 million barrels per day since 2008. Almost all of this increase in production has come from an increase in production of shale oil.

Shale oil is expensive to produce and much of it is only viable if oil prices remain higher than $70 per barrel. As Jensen puts it: “A high percentage of the industry breaks even with an oil price in the $55-65 range...With an oil price around $50, oil producers could go belly up, left right and centre.” This can't be good news for the United States because shale oil companies have been a major reason behind the job boom in the United States. And if they start shutting down, this will have an impact on job creation, which will in turn have an impact on consumer spending and US economic growth.The United States is the shopping mall of the whole world and if consumer spending slows down, it will have an impact on many exports of many countries."

Further, the oil exporting countries are losing out because of lower oil prices. “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,” writes Das.

These countries are now in a major problem. Saudi Arabia leads this pack and is now forecasting the biggest fiscal deficit in its history. Fiscal deficit is the difference between what a government earns and what it spends. The deficit for 2015 is expected to amount to $38.6 billion and was recently announced on state television. The Saudis can ride through this because they have a huge amount of foreign exchange reserves amounting to over $700 billion. Other oil exporters are not so lucky.

Nevertheless Saudi Arabia has plans to limit wage growth. As a Bloomberg report points out: “ The Finance Ministry said the government will continue to invest in areas such as education and health care, while exerting “more efforts” to curb spending on wages and allowances, which make up about 50 percent of spending.” This can't be good for global economic growth. What all these points suggest is that there are many negative impacts of falling oil prices, which are not being highlighted at all.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

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