Falling oil prices are a symptom of wider economic malaise not the cause. It is the malaise that is the real risk, along with the short-term negative feedback effects of low oil prices. Just as there is inertia on the supply side of the market, the demand side also takes time to rebalance, and its recovery is being offset by contraction in the oil and gas sector. Ross McCracken
Rising oil prices from 2003 were accompanied by predictions that such a sharp rise in the world’s most important energy commodity would bring the global economy to a juddering halt. This would occur at $40/barrel, then $60/b, then $80/b, but by the time prices breached $100/b in 2008, the doomsayers were forced to retreat back into their Trojan bars to reconsider their calculations.
It was a reminder that energy economists, and oil analysts in particular, suffer – no differently from anyone else – from a common heuristic, which is to over-estimate the significance of their own subject in the greater scheme of things.
A second equally understandable bias is the association of sharp changes in the oil price with crises. There is good reason for this, owing to the oil crises of the 1970s, the Iran-Iraq war of 1980-88, Iraq’s invasion of Kuwait in 1990 and the subsequent invasion of Iraq by US-led forces in 1990-91 and then again later in 2003. Sharp rises in the oil price are associated with bad events, leading on to a tendency to assume that high oil prices cause bad events.
However, the real cataclysm of recent years was the 2008/09 financial crisis, which had its origin in the financial world and had nothing to do with oil. The large-scale bail out of banks exhausted many governments’ ability to apply further fiscal stimuli, exposed the weaknesses of the eurozone and left interest rates so low that monetary policy as a means of boosting growth is not currently possible. Central banks resorted to ‘quantitative easing’, otherwise known as printing money.
Import dependencies
There is a parallel with the general treatment of energy commodity import dependencies. These are seen as bad and for good reasons. They represent a continual outflow of capital from the importing country and a clear security threat, owing to the importing country’s dependence on extended supply chains that can stretch back to politically and economically unstable centers of production.
These import dependencies sometimes stem from economic mismanagement, for example Nigeria’s dependence on imported oil products. However, for the most part they are a sign of robust economic health. They are a weakness borne of strength.
The largest import dependencies occur in the most economically successful countries, most notably the United States, but also Japan, Germany, Switzerland and more latterly China. These countries are so productive that they suck in base commodities above and beyond their domestic ability to produce them, which varies depending on their own natural resources.
High energy prices
Nor is there any clear association between low energy prices and economic strength. Those countries with the lowest energy prices tend to suffer from some variant of oil curse. Low energy prices encourage wasteful inefficiency and too high a dependence on one sector of the economy, leading to a very vulnerable revenue base for the governments concerned. The real weakness of an energy commodity dependency lies more with the producer than the consumer.
Japan has one of the highest – if not the highest – level of energy import dependency in the world. As a result, it has high domestic energy prices by global comparison. Yet it has been very economically successful and, despite lackluster growth in recent years, is still the third or fourth largest economy in the world. High domestic energy prices lead to greater efficiency, which is deployed to add value to raw energy imports, which can then be exported as processed higher value-added goods. Again, this is a sign of economic strength not weakness.
There is a definite positive correlation between high energy prices, raw material import dependency and economic health. So there should be little reason to attach a negative association to rising oil prices, or perhaps by extension to the cost of new renewables technologies. Energy importing countries can only sustain energy import dependencies because they have the means to make them affordable.
Reactive pricing
The oil price reacts to rather than leads economic growth; it is a symptom not a cause, although there are feedback effects. The rising and then high level of oil prices from 2003, through the 2008/09 financial crisis, until mid-2014 reflected many factors, but the primary one was rapid, energy-intensive growth in the Chinese economy. This occurred more quickly and relentlessly than the speed with which the supply side of the oil industry could react.
This was in part because of OPEC’s cartel behavior and the resource nationalism that kept world class oil and gas resources off limits to the International Oil Companies that might have developed them. But it also reflected the long investment cycle of the oil industry, which is not just rooted in the time it takes to explore and develop new resources, but in the oil services sector that allows that to happen.
To take an example, in 2003, there was a growing shortage of offshore rigs. Not only that, but there weren’t enough shipyards with the capacity to build new rigs. It has taken more than a decade for this key area of oil services to move from scarcity to surplus. This surplus is now being cruelly exposed by the drop in exploration and production activity brought on by the collapse in the oil price.
Different parts of the oil industry have different investment cycles, but all display significant levels of inertia once prices fall. New offshore rigs are still being constructed, despite the lack of demand for them; major oil and gas field developments are still coming on-stream, the investment decisions for which were taken when oil was above $100/b.
Shale has changed this landscape by reducing the time it takes to bring new wells into production, limiting the lag between changes in price and production levels. However, shale still makes up only a small proportion of the global oil industry and has its own inertia. In a low oil price environment, companies have a desperate need to protect cash flow and the only way they can do that in the short term is to maximize production and minimize investment. This accentuates a boom-bust cycle.
Moreover, OPEC is no longer acting as a cartel, and resource nationalism – already in reverse with the opening of the Iraqi oil patch – is generally weaker in times of low oil prices. Although uncertainties remain over Iranian exports, it is possible that, in the next decade, IOCs will have access to Middle Eastern oil resources on a scale unprecedented since before the Iranian revolution of 1979.
Slowing growth
It is demand that drives oil supply. The current drop in oil prices is the result of slower economic growth and a shift in the location of that growth from developing to developed countries. Given also environmental regulation, current and future GDP growth will be less oil intensive than in the preceding decade.
At the same time, the oil industry has caught up and finds itself in surplus across the board, not just in terms of actual oil production, but in terms of the capacity to increase production. This will serve to keep the input costs of exploration and production low for some years in direct contrast to the rapid inflation seen in the oil services sector from 2003-2013.
UK forecasting agency Oxford Economics published its latest global economic forecast in February. At 2.3%, it is the lowest since 2009. The company paints a worrying picture, pointing to signs that weakness in the real economy may be broadening. It sees deep recessions in Russia and Brazil, lower OECD growth and, indicative of the lack of policy levers available to governments, a resort to negative interest rates in Japan and Sweden.
Redistribution
Some observers have suggested that low oil prices are having a negative impact on world GDP, which means that it is possible to argue that rising and falling oil prices are both bad for the world economy. That isn’t necessarily as inconsistent as it seems, if it is argued that change itself is bad. But just as oil prices had little discernable impact on global GDP on the way up, the opposite idea that they will have an impact on the way down should be treated with caution.
The argument is that the sharp decline in oil and gas sector activity itself will reduce economic growth. There is some truth in this; there is no question that thousands of oil and gas sector workers have and are losing their jobs in the current downturn, while billions of dollars in investment spending has been wiped from oil company investment plans.
The oil and gas sector is suffering recession, and the sector makes up an important part of global GDP. This will be particularly felt in the US, where the shale oil and gas sector has been a major element in national GDP growth over the last decade. It is not just the size of the oil and gas sector that is important, but that it has been a core area of investment spending. Moreover, oil and gas are an important source of state revenue for many countries and reduced oil and gas revenues mean reduced government spending.
However, on a global scale, the oil price is essentially redistributive. Low prices mean more money stays in oil importing countries and less flows to the oil exporters. In turn, they are less able to import the processed goods that the oil importing countries produce. Consider also the downturn in oil and gas investment and social spending and it is certainly possible to paint a picture of downward economic spiral.
But low oil prices are still more symptom than cause. Lower growth exposes the economic weaknesses of countries like China, with its huge debt levels, and those of oil exporters critically dependent on oil revenues. It takes time for the redistribution of what was formerly oil money – from oil exporters to oil importers and from the oil and gas sector to other sectors of the economy – to be redeployed in useful ways. It represents a major reallocation of funds between countries and between economic sectors.
Demand response
In the classic textbook sense, low oil prices should stimulate demand, just as high oil prices encouraged demand destruction and substitution. But in the case of oil, there are mitigating circumstances; countries are keen to reduce oil use for environmental and security of supply reasons. Price is not the only factor.
Moreover, the sharp drop in wind, solar and lithium-ion battery costs might prove the launch pad for the electrification of personal transport. Sales of electric vehicles are still very low, but worldwide their growth curve is beginning to take on an exponential shape, which has been the hallmark of renewable technologies.
It made little sense to move towards the electric car if this meant greater imported fossil fuel use in the electricity sector, but as domestic renewable generation rises, the beginnings of a fully-sustainable domestic transport fuel cycle in the form of electricity is beginning to look more achievable. This raises the broader question of whether the oil industry is in the throes of a cyclical crisis, has a terminal illness, or both.
For OPEC the answer may be moot. OPEC’s current strategy, instituted by Saudi Arabia and the other Gulf Kingdoms, is a response not just to the rise of US shale oil, but to the threat of peak demand. It is also – whether OPEC more broadly appreciates it or not, and painful though it may be – the only way that the organization can hope to restore its former power.
Saudi Arabia cannot control the environmental agenda, but it can position itself and OPEC to extract maximum value from a multi-billion dollar industry facing historic decline. So short-term crisis or mortal threat Riyadh’s current strategy still looks like the best that can be done in a difficult situation. The ‘freeze’ on output growth announced in February by Russia, Saudi Arabia, Qatar and Venezuela does little to change this and in any case looks unlikely to be implemented.
Recession risks
Changes in the oil price over the medium to long term are essentially neutral for the world economy, and reflective of underlying growth or the lack of it, although they imply large redistributive short-term effects. The focus has been on when the supply-side of the market might rebalance, leading to a recovery in prices. This requires a major contraction in production, which should occur as a result of the drop in oil company exploration and production spend.
But it has been countered by growth in OPEC supply, which delays the time it will take to draw down the record high level of stocks. At the same time, it is causing long-term sectoral recession at the back-end of the oil market, the effects of which will be felt for years. This reduces the input costs for oil production, which makes higher-cost non-OPEC production less high cost and more competitive, which also delays the major contraction in supply required.
However, the supply side of the market also needs time to rebalance. There will be some low price demand response, as shown, for example, by Chinese industrial gas users switching to LPG and South Korean companies shifting from LNG to cheaper Bunker-C fuel oil, but overall demand will be held in check in the short term by the permanent demand destruction of the last decade, further environmental regulation, and by the negative growth effects of contraction in the upstream oil and gas sector and reduced government spending.
Falling oil prices occur at a time of slowing growth and therefore by definition in a riskier economic environment. Slower growth creates a higher risk of company and sovereign default because they reflect a weaker global economy and expose the fact that dependence on a single export as an oil producer is a greater vulnerability than dependence on oil imports.
With that high risk level comes the possibility of a downward deflationary spiral from which it may prove hard to recover. This is particularly so at a time when interest rates are already so low that governments have lost monetary policy as an economic lever, and at a time when fiscal discipline is necessary because of the expanded level of debt caused by the financial crisis. This, rather than low oil prices per se, have stripped governments of the economic levers to stimulate the economy.
The redistribution of what were formerly oil funds to other sectors of the economy will filter through, but it will take time for them to be deployed productively. The real threat is that economies like China are too weak to redeploy that capital effectively because of high debt levels. The feedback effect of falling oil prices is like getting a cold on top of the flu, but it is the weakness caused by the flu that has made the world susceptible to the cold in the first place. And, in a weakened state, a cold can prove a killer.
This article was published in the March 2016 issue of Platts Energy Economist (issue 413).
By : Platts