Falling oil price to boost global growth

By Leith van Onselen

IMF economists, Rabah Arezki and Olivier Blanchard, have penned a useful primer on oil prices, which argues that the heavy slide in prices could help to boost global economic activity by up to 0.7% next year, but that the impact will be vastly different across economies. The key points of the report are as follows:

Overall, we see [plunging oil prices] as a shot in the arm for the global economy… we find a gain for world GDP between 0.3 and 0.7 percent in 2015, compared to a scenario without the drop in oil prices.

…oil importers among advanced economies, and even more so emerging markets, stand to benefit from higher household income, lower input costs, and improved external positions. Oil exporters will take in less revenue, and their budgets and external balances will be under pressure…

Risks to financial stability have increased, but remain limited. Currency pressures have so far been limited to a handful of oil exporting countries such as Russia, Nigeria, and Venezuela. Given global financial linkages, these developments demand increased vigilance all around…

The fall in oil prices provides an opportunity for many countries to decrease energy subsidies and use the savings toward more targeted transfers, and for some to increase energy taxes and lower other taxes.

The authors find that both demand and supply-side factors are to blame for the sharp drop in oil prices, which have plunged by 50% since June and 40% since September:

ScreenHunter_5621 Dec. 23 08.03

Revisions between June and December of International Energy Agency forecasts of demand (see Chart 3), combined with estimates of the short run elasticity of oil supply, suggest that unexpected lower demand between then and now can account for only 20 to 35 percent of the price decline…

On the supply side, the evidence points to a number of factors, including surprise increases in oil production. This is in part due to faster than expected recovery of Libyan oil production in September and unaffected Iraq production, despite unrest…

A major factor, however, is surely the publicly announced intention of Saudi Arabia—the biggest oil producer within OPEC—not to counter the steadily increasing supply of oil from both other OPEC and non-OPEC producers, and the subsequent November decision by OPEC to maintain their collective production ceiling of 30 million barrels a day in spite of a perceived glut…

The authors also believe that the supply glut will run for some time:

…unless the pain of lower revenues leads other OPEC producers and Russia to agree to share cuts more widely in the future, the shift in strategy is unlikely to change soon. Another hypothesis is that it may be an attempt by OPEC to reduce profits, investment, and eventually supply by non-OPEC suppliers, some of whom face much higher costs of extraction than the main OPEC producers…

ScreenHunter_5622 Dec. 23 08.10

The falling oil price should, however, lead to some shake-out of US shale oil producers:

…the break-even prices—the oil price at which it becomes worthwhile to extract—of the main United States shale fields (Bakken, Eagle Ford and Permian) are typically below $60 per barrel…

ScreenHunter_5623 Dec. 23 08.12

At current prices (around $55 per barrel), Rystad Energy’s projections suggest that the level of oil production could decline but only moderately by about less than 4 percent in 2015. Rates of return will be significantly lower, however, and some highly leveraged firms that did not hedge against lower prices are already under financial stress and have been cutting their capital expenditure and laying off significantly.

Thus, other things being equal, the dynamic effects of low prices on supply should lead to a decrease in supply…

Overall global growth is expected to increase by o.4% and 0.8% by 2016, under two scenarios modelled by the authors:

  • Scenario 1 assumes that the supply shift accounts for 60% of the price decline reflected in futures markets;
  • Scenario 2 assumes that the supply shift accounts for 60% of the price decline at the start but that the shift is partly undone over time, with its contribution to the price decline going gradually to zero in 2019.
ScreenHunter_5624 Dec. 23 08.16

Oil importers would gain significantly from a prolonged cratering of oil prices, via three main channels:

  1. An increase in real income on consumption;
  2. A decrease in the cost of production of final goods, and in turn on profit and investment;
  3. The effect on the rate of inflation, both headline and core.

The implications for GDP, under the two scenarios mentioned above, are shown in the next chart:

ScreenHunter_5625 Dec. 23 08.23

The effect on China in both scenarios are larger than those for Japan, the United States and euro zone countries. For China, GDP increases 0.4-0.7 percent above the baseline in 2015, and 0.5-0.9 percent in 2016. For the United States, GDP increases 0.2-0.5 percent above the baseline in 2015, by 0.3-0.6 percent in 2016. (The simulation assumptions do not take into account the potential offset from some policies that governments may implement following the fall in oil prices.  For example, China may decide to tighten monetary or fiscal policy in response to the oil price decline).

Oil exporters, by contrast, would be badly affected:

In all countries, real income goes down, and so do profits in oil production; these are the mirror images of what happens in oil importers…

…energy accounts for 25 percent of Russia’s GDP, 70 percent of its exports, and 50 percent of federal revenues. In the Middle East, the share of oil in federal government revenue is 22.5 percent of GDP and 63.6 percent of exports for the Gulf Cooperation Council countries. In Africa, oil exports accounts for 40-50 percent of GDP for Gabon, Angola and the Republic of Congo, and 80 percent of GDP for Equatorial Guinea. Oil also accounts for 75 percent of government revenues in Angola, Republic of Congo and Equatorial Guinea. In Latin America, oil contributes respectively about 30 percent and 46.6 percent to public sector revenues, and about 55 percent and 94 percent of exports for Ecuador and Venezuela. This shows the dimension of the challenge facing these countries.

Energy firms would also be badly affected:

The proportion of energy firms with an interest coverage ratio (the ratio of cash flows to interest payments) below 2 stands at 31 percent in emerging countries, indicating that some of these companies may indeed be at risk.

Global exchange rates would also shift:

Lower oil prices also typically lead to an appreciation of oil importers’ currencies, in particular the dollar, and to a depreciation of oil exporters’ currencies. The drop in oil price has contributed to an abrupt depreciation of currencies in a number of oil exporting countries including Russia and Nigeria…

And there are risks for financial stability:

One of the lessons from the Great Financial Crisis is that large changes in prices and exchange rates, and the implied increased uncertainty about the position of some firms and some countries can lead to increases in global risk aversion, with major implications for repricing of risk, and for shifts in capital flows. This is all the more true when combined with other developments such as what is happening in Russia.

Overall, it’s a useful report that is worth reading in full.

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