Why Oil is Cheap and What It Could Mean for Your Country Lauren Goodwin Economics, Government, Politics & Economics In a world of Eurozone showdowns between Greek and German, economic anxiety across the globe, and a sluggish recovery from debt and derivatives, cheap energy is a rare – but complex – economic bright spot. Energy price disruptions represent the most complex of economic challenges. The direction and size of impact on countries and particularly emerging markets varies considerably. It’s no surprise that the recent 60% decline in oil prices has attracted so much media and corporate attention. Prices will eventually rise again, but supply-side fundamentals will cause oil prices to stabilize at lower levels than in most of the previous decade. As an export, a revenue source for governments, and a necessary input to production, this vast redirection of energy price assumptions has serious implications for people and countries in every region of the world: when oil prices decline in developed countries, social safety nets and public spending are at risk and governments may be inclined to raise interests rates. In emerging markets, consumers can gain disproportionately when energy prices fall. No one truly knows where oil prices will settle, but considering the fundamentals of energy prices and their impacts to individual countries can help analysts and businesses to understand which countries will be hit – or helped – by this major driver of global economic change. Why have prices declined? Downward pressure on energy prices been strong for quite some time; in fact, the EIA and IMF have long predicted sizably lower prices beginning in 2014 However, while these organizations foresaw a sustained price decline, the alignment of four factors has prompted a sharper price disruption than anticipated: Pervasive low growth in the Eurozone and cooling growth in large emerging markets such as Brazil and China reduce global demand for energy, lowering prices. The accompanying low interest rate environment in developed markets has kept investment in additional energy resources affordable. The tendency toward short-term supply disruptions has faded. Tensions related to Iran’s nuclear program have de-escalated, Iraq and Syria have sustained production despite internal turmoil, and OPEC’s internal politics have kept supply conditions permissive. A strong dollar compared to depreciating global currencies puts significant downward pressure on the price of oil. Since the end of World War II, oil has been priced in US dollars. This means that when the dollar fluctuates in value, it affects every other nation’s consumption and production of crude. As the dollar strengthens, both consumers and commodities traders have less purchasing power where commodities are concerned. The result is less demand for those commodities and lower prices. Hydraulic fracturing (fracking) technology has allowed a new source of oil to come online more quickly and cheaply than before, creating a supply glut that decreases prices With each of these drivers intact for the near term, there is no indication that oil prices are likely to increase in 2015. In fact, demand is unlikely to catch up to supply until 2017, keeping prices low for the next three years. Where will prices stabilize? Fracking technology has changed, to an extent, the way that the world should think about its energy resources. Unlike oil wells, which take 3-4 years to bring supply online, shale wells require only 30-60 days from the point of investment to be productive. The fast-moving nature of shale has thus limited, although not entirely discontinued, the ability of major exporting markets to disrupt supply. Of course, even shale oil is a non-renewable resource, and the economics of supply and demand will be reminded soon that scarcity does have a market price. However, while prices will eventually rise, shale oil (and other unconventional oil production) will minimize the size and extent of energy price increases in upcoming years. Oil prices are known to fluctuate due to the high frequency of their trading on international financial markets. However, slight upticks in prices as seen in February 2015 do not indicate a long-term turnaround of energy prices. In order to understand where oil prices might stabilize, traders are looking more to oil and rig counts to understand where supply is coming offline. While rig count is decreasing in the United States, the pace of that decrease is slowing as efficient and lower-cost rigs remain active. Meanwhile, total supply has remained steady as as storage has increased, keeping prices low. What does the decline mean for energy exporters? Media and corporate attention has focused on struggling oil exporters like Russia, Venezuela, and Iran. Indeed, countries that rely disproportionately on energy export revenues without diversification or economic controls are vulnerable to decreases in energy prices. When small price declines are matched with currency depreciation, governments receive more local currency for each barrel of oil sold. However, with the extent to which prices have fallen since July 2014, oil exporters are at a loss. Energy exporters lose as oil prices decline mainly through the channel of government revenue. The declining value of this key export means that social safety nets, subsidies, and public spending are at risk. Governments experience pressure to raise interest rates to keep currencies from depreciating, which exacerbates low public confidence and contributes to lower spending. Where government spending, exports, and consumption decline, political unrest becomes more likely. Each of these dynamics is in effect in energy exporting markets as a result of current energy price declines, disrupting economic growth. And importers? Although the view for energy exporters is grim, a low energy price environment creates more winners than losers. As consumers in emerging markets typically spend more on energy as a percentage of wallet share than consumers in developed markets do, they gain disproportionately when energy prices fall. Transportation costs for consumers and businesses also decline, increasing margins for companies that control their supply chains. In markets where growth is slowing, companies can pass additional savings onto consumers. In the Philippines, for example, the lack of existing energy subsidies mean that consumers gain immensely from declining energy prices and can spend their cost savings on discretionary items. However, the pace of gains to governments and consumers in energy importing markets is much slower than the pace of loss to exporters, and their extent depends on how much governments subsidized energy before. Since governments in emerging markets heavily subsidize energy costs for their citizens, consumers might not see prices decline much, if at all. In Egypt, for example, subsidy removal will mean that consumers actually pay higher transportation and food prices overall. In developed markets, such as Europe, heavy regulation of energy markets prioritizes more expensive renewable energy on their grids, meaning that consumers will not see lower oil prices hit their pockets. Moreover, fears of deflation in the Eurozone, exacerbated by cheaper oil, might see European consumers rein in spending and cancel out potential gains from cheaper energy. How does it all add up? All else equal, oil at $50 per barrel provides a global GDP increase of about 1.0%. Unfortunately, all else is not equal in the global economic picture for 2015. Slowdown across most major markets outside of the US has resulted in the IMF’s downward revisions of global GDP growth to 3.3% from 3.7%. Depreciating currencies and high financial market volatility reduce confidence and slow growth even where oil prices are falling. Rather than boosting global growth, then, lower energy prices are keeping slowing growth from falling further. This spells a complicated environment for governments, businesses, and households this year, but not necessarily a bad one. Governments can use lower prices to reduce their subsidies burden; businesses will see lower transportation costs; households will have more to spend on discretionary goods. There are a wealth of opportunities that cheaper energy can provide, but it is up to the actor to seize them. Further Reading: Michael Ross, The Oil Curse: How Petroleum Wealth Shapes the Development of Nations Countries that are rich in petroleum are less democratic, have less economic stability, and suffer from more frequent civil wars than countries without oil. What explains this oil curse? And can it be fixed? Michael Ross is the best-known scholar on the causes and consequences of “the oil curse” and, after years of back and forth in major journal articles, he lays out the complete argument in this landmark book. Victor Menaldo, The Institutions Curse: State Weakness and Oil Discovery Ross’s most formidable challenger is Victor Menaldo who argues that resources are more of a blessing than a curse. Indeed, the real story that needs to be told is one of poor state institutions rather than the presence of an abundance of energy. Geoffrey Heal, The Economics of Renewable Energy An economy run entirely on renewable energy is the dream of almost every energy policy wonk in Washington, yet not a great literature exists on the economics of renewable energy. Here, Geoffrey Heal summarises the major findings of the field as well as discusses the problem of “intermittency” and energy storage. The Oxford Institute for Energy Studies The Oxford Institute for Energy Studies produces seemingly limitless numbers of analyses on energy topics from gas demand in North America to pipeline issues in Ukraine. When an issue in energy supply pops up, it seems like OIES has done an analysis previously saying how it had come to pass. Daniel Yergin, The Prize: The Epic Quest for Oil, Money and Power. The Pulitzer prize winning definitive history of the oil industry. “The Prize” is required reading for all people entering any part of the oil business. Daniel Yergin traces the history of oil from Yale’s Benjamin Silliman Jr.’s report on “rock oil” for investors led by George Bissel in 1855 to the lead up to the First Gulf War. US Energy Information Administration The EIA is the United States’ premier source for energy information. Their International Energy Outlook, updated regularly, provides insights on supply and demand trends worldwide, forecasts for prices, and possible disrupters. Image credit: *** Fanch The System !!! *** via Flickr
