Oil prices and the global economy: “Oil’s
well” “Oil’s not so well”
Oil prices have decreased dramatically over
the past year. The US has increased fracking, extracting oil from shale
reserves and thus increasing the global supply of oil. This has been compounded
by the fact that Saudi Arabia has refused to cut back on oil production, hoping
that the higher prices of oil would force out the US’ shale industry, thus
increasing her own market share. Meanwhile, there has been decreasing demand
from China as her economy experiences a ‘slowdown’ and shifts from manufacturing
to the service sector. As China is the largest importer of crude oil this has
dampened global demand. Both of these factors have driven the price of Brent
crude oil to below $50 a barrel this month. The effects of such a decrease in the
price of oil on the economy will depend on whether the low prices are sustained
in the future. If prices remain at $50 a barrel, then net oil importing
countries, such as the UK, can stand to benefit from the decrease, whereas net
oil exporting countries could lose.
Increasing real household incomes
With a lower global price of oil, the cost of
production for oil-intensive sectors in the UK, such as agriculture and the air
transport industries, should decrease. A decrease in production costs should
result in the decrease in consumer prices, thus increasing consumer surplus.
For example, transport costs could decrease, thus resulting in cheaper
manufacturing costs. Indeed, land transport in the UK is very competitive,
meaning that prices are very likely to be passed to consumers, namely in the
manufacturing businesses. Moreover, with low prices, consumer demand could
increase for these oil-intensive products, and so businesses may have an
incentive to invest in capital, thus increasing employment. Indeed, PWC have
modelled the effect of a permanent decrease in oil using a dynamic computable
general equilibrium (CGE) model, predicting that with a decrease in the price
of oil to $50 per barrel, the UK economy would see the creation of an
additional 90 000 jobs by 2020. This in turn could be expected to increase
consumption in the economy, as more people are employed. Moreover, there is
also the potential that real wages would increase as the demand for labour
increases in oil-intensive industries. All of these effects would increase real
household incomes, and thus consumption could be expected to increase in less
oil-intensive sectors of the economy as well, thus increasing real GDP. Figure 2 highlights the effects of a decrease in oil price through the economy.
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| Figure 2: The effect of a decrease in oil price on the economy |
However, it should be noted that, “the
stickiness of downward price adjustments also means that the impact of the oil
price shock takes time to filter through the economy.” (PWC, 2015) PWC have
estimated that GDP will rise by an additional 1.4pc between 2015 and 2016 due
to rising real household incomes. This is highlighted in Figure 3 below, where
‘scenario 1’ highlights the projected increase in GDP if the price of oil remains
persistently low, at $50 a barrel. However, after 2016 the percentage
difference from the baseline would then decrease to 0.6pc. This is because
other manufacturing nations’ products would also become cheaper, due to the
decreased global price of oil, thus increasing competition with the UK’s domestic
firms and so reducing the UK’s benefit.
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| Figure 3: The impact of persistently low oil prices on the UK's real GDP |
Moreover, as oil prices decrease, the total
sterling value of imports would decrease. Coupled with the fact that the total
sterling value of exports could also increase, (if prices decrease as a result
of lower production costs), this would thus help to reduce the UK’s trade
deficit, and so the current account deficit. However, this would only have a
very minimal effect because the wealth effect would result in more goods being
consumed domestically, and so there would be a smaller increase in the sterling
value of exports than would be the case without the wealth effect. Furthermore,
there would also be a smaller decrease in the sterling value of imports, as the
wealth effect would encourage domestic citizens to consume more imported goods.
Deflation
Falling oil prices are thought to be the main
reason behind the fall in the inflation rate to around 0pc. Although increasing
aggregate demand, and increasing real wages, should increase the rate of
increase in inflation, the reduction in the cost of various domestic and
imported products is expected to outweigh this inflationary pressure and so
deflation may come to haunt the UK’s economy.
We only need to look at the other side of the globe at Japan to see the
effects of deflation: ‘a lost decade’. Although Japan is one of the world’s
greatest importers of oil, if low prices persist, this could hinder Abe’s aim
of combating deflation. Higher energy prices in Japan have had the result of
pushing inflation higher, but lower prices could reduce the rate of increase of
inflation and may result in deflation, if other policies are not implemented to
mitigate the effects. Lower oil prices may
encourage consumers to postpone their consumption, as they wait for prices to
decrease still further, which would thus increase their purchasing power. This would
also lead to business’ profits falling, and so investment is delayed. This in
turn could decrease the real wage rate and even lead to a rise in unemployment,
which would lead to even less consumption and also a greater rate of deflation.
On the other side of Europe, Russia is expected
to suffer incredibly. Its main export industry is oil, and 52pc of all the
government’s tax revenue is from this sector of the economy. Thus, falling oil
prices will result in the government’s budget deficit increasing, thus forcing
the government to increase taxes or impose austerity measures. This could lead
to further social unrest. This, coupled with western sanctions on oil, has
contributed to the currency’s deprecation in the past year.
Scotland's Woes
Moreover, the UK will not escape the negative
effects of falling oil prices. As a result of the falling demand for oil, 1.5 million
barrels of oil are being exported per day in Scotland, and thus this has led to
a direct loss of 65 000 jobs. This is because extracting oil from the North Sea
is relatively expensive compared to extracting oil in Saudi Arabia, for
example, and so contraction was necessary. This in turn has caused a negative
multiplier effect in Aberdeen. For example, due to fewer workers, there has been
a 40pc decrease in taxi journeys, and so taxi drivers have seen their incomes
fall, resulting in a decrease in aggregate demand in the local economy. The
output could decrease even further in the future because if the price of oil
remains persistently low whilst current reserves deplete, it would become
uneconomical to extract oil from deeper in the sea, as total costs would exceed
total revenues, and so the North Sea Oil industry would contract. Undoubtedly,
this would weaken Scotland’s ‘Yes’ campaign, because it would become
increasingly apparent that relying on North Sea Oil to fuel Scotland’s economy
would be implausible.
Moreover, due to a decrease in output and
falling oil prices, revenues would decrease, and so the UK government’s
revenues from the oil industry, which includes Corporation Tax, the Supplementary Charge and the Petroleum Revenue Tax, would also decrease. However,
this is not expected to outweigh the increase in government revenues from an
increase in tax revenues, especially from income tax and VAT, as employment and
wages increase, as explained above. Therefore, not only would this increase in
revenue decrease the budget deficit, as the government would receive more money
from taxes and be paying out less in unemployment benefits, but it could also,
as a result, lower the UK’s current account deficit.
Moreover, it should be noted that, the decrease in price of oil could delay investment into renewable forms of energy, as renewable energy would be relatively more expensive than oil, and so demand would be lower, and so profits would be expected to be lower in the industry as well.
Saudi Arabia
Saudi Arabia, OPEC’s leading member, could
provide a remedy. By reducing her own production, she could increase the price
of world oil, mitigating the negative effects for emerging economies that rely
on exporting oil, such as Venezuela. However, this is very unlikely to occur.
Tim Bowler, a Business reporter at the BBC, argues that Saudi Arabia may want
to keep prices low so that the US shale oil and gas industry suffers from low
prices, thus forcing the US to cut production and potentially leave the market,
in turn increasing Saudi Arabia’s market share. This has the potential to work
in Saudi Arabia’s favour because the US fracking companies have higher costs
than the OPEC nations, and so the lower prices would have a greater impact on
the shale industry than the oil industry, in terms of the probability of
survival.
Moreover, in the 1980s, Saudi Arabia reduced oil production from
10 million barrels per day to 2.5 million per day, in order to decrease supply
and so increase prices. However, this had a negative effect on Saudi Arabia’s
economy because other OPEC members did not follow suit. Therefore, prices
remained low and Saudi Arabia suffered from low revenue and a budget deficit,
accumulating piles of debt. Moreover, it should be noted that Saudi Arabia has
built up large foreign currency reserves, and so her currency would not
depreciate as fast as the currencies of emerging nations, who have smaller
foreign currency reserves. This is because Saudi Arabia can use the currency
reserves to buy her own currency, decreasing the supply of her currency and so
ensuring that it maintains its value and so that the value of oil exports does not decrease further. Therefore, although a reduction in the
supply of oil may be favourable for emerging markets, due to an increase in the price of the commodity, it seems highly unlikely
that Saudi Arabia would restrict oil production, because she stands to benefit
more from the current, low oil prices.
So, is "oil well"?
Therefore, for countries such as Britain who export most of their oil, "oil's well". With falling prices of oil, manufacturing firms are expected to pass on these benefits to consumers, thus increasing their disposable income and creating demand in other areas of the economy. This should increase business confidence and lead to decreased unemployment. The tax revenues raised from greater VAT and Income Tax should outweigh the negative effects of the decrease in revenues from the oil industry in Aberdeen. Thus, this should help the Conservatives in their aim of reducing the budget deficit. Coupled with a reduction in the trade deficit, the current account should also improve. However, emerging markets who are heavily dependent on exporting oil are expected to suffer as lower prices result in lower revenues; "oil's not so well". This could, however, be mitigated by foreign currency trading, ensuring that the price of the domestic currency does not appreciate, which would result in even lower revenues.
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