Chris Giles
December 15, 2014
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Inflation and strong dollar could curb global economic impact
Suddenly the world is awash with oil. A surprise surge in production and weaker than expected global demand for crude have sent oil reserves soaring and prices tumbling. The 40 per cent drop in the oil price to around $60 a barrel since June is by far the biggest shock for the global economy this year. Similar episodes in the past tell us the consequences are likely to be both profound and long lasting. Normally, economists would add “positive” to this list, but doubts are surfacing as never before.
The scale of the current oil shock is difficult to exaggerate. While financial markets and commentators were obsessed by rising geopolitical tensions and the latest twists in central banks’ policies in the US, Europe and Japan, even larger forces in oil markets went largely unnoticed. As late as October, a “key concern” of the International Monetary Fund was the risk of an oil price spike caused by geopolitical tensions. Instead, rising production and weaker demand growth have left suppliers competing to find willing customers.
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Rich country stocks of crude oil have defied the onset of the northern hemisphere winter and risen to their highest level in two years, according to the International Energy Agency. West Texas Intermediate crude oil prices dropped from more than $100 a barrel in June to less than $60, with the European Brent oil prices following the same downward path. Even a slight uptick yesterday cannot disguise the downward trajectory of the price.
Rather than geopolitical tensions in Ukraine and Iraq causing an oil shortage and price spike, as foreseen in the IMF scenario, the causality is flowing from economics to politics. The plunge in oil prices now threatens Russia’s living standards and public finances to the point where it will start 2015 as a devalued and belligerent nation with nuclear weapons. In the Middle East, the funds to finance vicious conflicts in Iraq and Syria face greater pressures, which promise to stretch all sides. And the US is less likely to want to play global policeman now that it can satisfy almost 90 per cent of its energy needs from domestic sources, up from 70 per cent as recently as 2005.
In normal times, the broad effects of the oil price drop on the global economy are well known. It should act as an international stimulus that will nevertheless redistribute heavily from oil producing countries to consumers and the longer the new prices endure, the more profound will be the effects on the structure of industries across the world.
But this time, economists are actively debating whether the world has changed and other moving parts — such as falling inflation levels and the strong dollar — will throw sand into the works of the usual economic relationships.
But when oil prices fall, there is no iron law that enhances global economic growth. The main effect is a huge redistribution from oil producers, who receive less for the effort of extracting the black gold, to consumers who benefit from cheaper transportation and energy, enabling them to spend more money on other goods and services or to save their windfall.
Most economists still agree with Christine Lagarde, IMF managing director, who this month said that “it is good news for the global economy”. The positive effect on growth should arise because oil consumers tend to spend more of their gains than oil producers cut their consumption.
Global impact
Gabriel Sterne of Oxford Economics explains, “producers have financial surpluses and don’t tend to cut back, while lower prices redistribute income to those who have a higher propensity to consume and to invest”. The scale of the global effect is significant. Oxford Economics estimates that every $20 fall in the oil price increases global growth by 0.4 per cent within two to three years. The IMF’s core simulations suggest a similar size of the effect, so the $40 reduction in price would more than offset the total 0.5 percentage point downgrades to the IMF’s world economic growth forecasts for 2014 to 2016 over the past year. That boost is then amplified if it generates a subsequent lift in confidence, encouraging companies to invest and spend.
If the usual effect on the world economy is large, it is always dwarfed by the swings that will benefit some countries and hit others. The big winners will be countries that are simultaneously heavy users of energy and largely dependent on oil imports. Moody’s, the credit rating agency, calculates that countries “battling high inflation and large oil subsidy bills, such as Indonesia and India, will benefit most from a lower price environment”.
Looking at 45 different economies, Oxford Economics agrees that emerging economy oil importers are likely to be the main winners. Most advanced economies also gain significantly, although as they have less dependence on oil for every dollar of gross domestic product so their proportionate gains are smaller. A further boon for many emerging economies is that the fall in fuel prices enables countries to cut fuel subsidies, removing significant pressure from the public finances. Lord Stern of the London School of Economics says “this is exactly the right moment to remove fossil fuel subsidies and intensify carbon pricing”.
For oil exporters, however, the outlook is darker. Those which have tended to spend rather than save oil revenues have the least capacity to adjust to the new reality. Moody’s estimates that Russia and Venezuela will be hardest hit, since they have “large recurring expenditure that may be politically challenging to cut”. The largest oil producer, Saudi Arabia, has much greater fiscal buffers since it saved more than it spent. Currency markets have already reacted brutally to those countries it considers vulnerable, pushing down the rouble 40 per cent against the dollar over the past six months, for example.
So far, so normal. But this time there are more voices than usual suggesting expectations of a global boost are deceptive. Stephen King, chief economist of HSBC, believes lacklustre demand in China, Japan and Europe over the summer was the primary cause of the collapse in prices so the traditional “lower oil prices good: higher oil prices bad” story is “no longer so obviously true”.
He argues that optimism following an oil price fall in economic estimations is based on positive supply-side developments for the western developed world, but “there are plenty of situations where falling oil prices are merely symptoms of a wider malaise”.
Deflation fears
Mr King argues that much of the past gains from oil prices have come from lower interest rates associated with falling inflation, which cannot happen when monetary policy is already stimulating economies as hard as it can. If households in China, Europe and Japan feel there are reasons to save any windfalls they receive, the global demand boost will be severely restricted.
And one reason consumers might be less willing to open their purses and wallets this time is that a spectre of low inflation stalks many advanced economies. While stable or falling prices make people better off, they also potentially threaten a prolonged period of stasis if households prefer to “wait and see” before spending their money.
Anjli Raval and John Burn-Murdoch assess the fiscal break-even price, an important metric for assessing a state’s vulnerability to swings in the oil market
That attitude, encouraged by the possibility of lower prices tomorrow could encourage companies to delay investment and households to put off consumption, generating a self-fulfilling prophesy of soggy growth and gently falling prices.
The threat is not to be dismissed lightly. Oxford Economies estimates that with an oil price of $60 a barrel, 13 European countries will see their inflation rates fall below zero, at least temporarily, in 2015.
Aware of the danger that oil could create persistent disappointment rather than a shot in the arm, Peter Praet, chief economist of the European Central Bank, said monetary policy in Europe did not have the normal luxury of simply assuming lower oil prices would boost incomes and spending this time. “In these conditions monetary policy needs to react,” he said.
Other reasons why the usual boost to demand might be more muted include the sharply rising dollar, which ensures that domestic oil prices outside the US have not fallen by anything like the 40 per cent headline figure.
Some clues regarding the validity of the new fears are provided by history. In 1986, the oil price more than halved after Opec failed to control supply, triggering a global economic surge that accelerated global growth to a peak of 4.6 per cent in 1988, a rate that would not be achieved again until 2000.
In 2008, acute weakness of global demand led to an oil price decline from $133 to $40 a barrel, but even with fears of deflation, cheaper oil helped generate a rebound in growth in 2010.
History, then, is kind to the traditional view of the potency of cheap oil in stimulating global economy in good times and bad. But economists also know that history has not been a good guide to many economic trends over the past six years.
Though a global boost is more likely now than it was, there is no guarantee cheap oil will cast the magic spell this time that it always has in the past.
From China to Venezuela and countries in-between — who loses and who gains
Mexico
Mexico is opening up its oil and gas sector to private investment after nearly 80 years of state control. But it stands to see investment squeezed as a consequence of the oil price plunge. Companies vying for the chance to drill $100m wells say that they may scale back their interest. The silver lining for Mexico is that it imports about half its petrol so lower prices are a bonus. Crude accounts for less than 15 per cent of Mexico’s exports and it has a hedging programme which it says will shield it from the impact of price falls in 2015. A $20-a-barrel fall in the price of Mexico’s oil next year would add up to less than 1 per cent of GDP, “not insignificant but still manageable from a fiscal perspective”, according to Moody’s, the rating agency.
US
Falling oil prices may slow down the shale revolution but are still good news for the US economy, as the cash saved on filling up a car swells the wallets of hundreds of millions of consumers. The fall in oil prices so far will provide the US public about $75bn a year to spend on other goods — about 0.7 per cent of total US consumption. Analysts predict a fall in oil investment but Goldman Sachs pegs it at no more than 0.1 per cent of GDP. Lower oil prices have made economists more confident about the outlook for 2015 with HSBC raising next year’s growth forecast from 2.6 per cent to 2.8 per cent. Cheaper oil will weigh on already low inflation but the Federal Reserve is treating that effect as a one-off.
Eurozone
The EU imports 88 per cent of its oil but its celebrations over plunging prices have been muted. At first glance, lower energy prices come as a welcome relief to European industry when it is struggling to retain competitiveness in relation to the US. In terms of consumer prices, Mario Draghi, president of the European Central Bank, called cheaper oil “unambiguously positive”. Jens Weidmann, a member of the bank’s governing council, described the low crude price as being “like a mini-stimulus package”. But Mr Draghi is also quick to identify the risks when the EU already fears that inflation is alarmingly low and could be veering towards deflation. Many countries have looked to inflation to alleviate the debt burden that is restraining their spending power.
Mr Draghi warned that low oil prices could become “embedded” in low wages. Oil’s freefall has also battered European stocks, particularly London’s energy-heavy FTSE. Analysts expect that major projects in Europe, such as in Britain’s North Sea, will be put on hold. Europe’s leading economy, Germany, is shifting towards renewable power but petroleum still makes up about a third of its energy consumption. However, business confidence has been boosted by cheap oil and the decline of the euro. German GDP is expected to grow by 1.5 per cent in 2015, according to the Munich-based Ifo Institute, of which a quarter of a percentage point is attributable to the drop in oil prices, the institute said in a forecast last week. Ifo said the oil price fall would boost overall economic activity “not least through an increase in domestic purchasing power.”
UK
With rapidly declining oil extraction in the North Sea, most of Britain is a modest winner from the sharp drop in the oil price. For Aberdeen, the oil capital of Scotland and the UK, outlook is bleak since the granite city specialises in deep sea oil extraction technologies, which are increasingly uneconomic with cheaper oil. But Aberdeen’s loss is the rest of the UK’s gain. Lower fuel prices have pulled inflation down to 1 per cent and have eased pressures on household and company budgets, raising confidence and improving the growth prospects for 2015. The oil industry accounts directly for less than 2 per cent of national income and although ancillary service industries are also important, they do not change the picture of reasonable gains for the vast majority not fully offset by large losses in the oil industry. For the public finances, the outlook is less rosy as the oil industry is heavily taxed, so greater spending elsewhere will not fully offset another loss in oil revenues. For Scottish nationalists, the loss of oil revenues would undermine any arguments in future that Scotland would be better off as an independent country.
Norway
Norway appears to be in one of the best positions of any producer. Oslo not only has the world’s largest sovereign wealth fund — double the size of its economy at $870bn — but it can also tolerate a lower price. According to Fitch, even at a price of $40 a barrel Oslo would balance its budget, the lowest threshold for all the oil producers covered by the rating agency. But Norwegian authorities are still worried given the Nordic country’s dependence on oil. The central bank cut interest rates unexpectedly to a record low last month despite a frothy housing market. Oystein Olsen, the governor, worries that an oil price below $70 could cause oil companies to cut back on investment and delay projects. Exploration of the Arctic — touted as Norway’s next big oil frontier after the North Sea — is seen as particularly at risk for western Europe’s biggest producer.
Russia
For the Russian economy, the drop in the oil price and the Ukraine crisis have whipped up a perfect storm. As oil and gas account for 75 per cent of the country’s exports and more than half of its budget revenues, its currency moves in lockstep with the oil markets. The rouble, which had already been devaluing under the pressure of geopolitical risks, has plummeted since the fall in oil gathered pace. As a result, the $600bn burden that Russian banks and companies owe foreign creditors is getting heavier by the day — a worry that is even more serious because western sanctions bar most of these borrowers from refinancing this debt with US or European banks. With Russia reliant on imports for almost everything except commodities, inflation has soared to 9.4 per cent and is expected to hit 10 per cent by the year-end.
Further reading: Can Vladimir Putin’s popularity weather a perfect economic storm?
Turkey
Mehmet Simsek, Turkey’s finance minister, argues that his country should no longer be seen as one of the “fragile five” emerging economies — because the oil price drop helps narrow Ankara’s current account deficit, a notorious economic weak spot. Turkey relies heavily on foreign fuel — last year’s energy import bill was $56bn — but officials say the deficit narrows by more than $400m for each $10 fall in oil. The impact on consumers is less favourable, since Turkey has some of the highest petrol taxes in the world. The IMF has warned that the economy remains “sensitive to changes in external financing conditions” and that a fundamental fix would require higher savings and ambitious structural reforms. Ankara reported disappointing growth figures last week while the lira plunged to an all-time low against the dollar yesterday amid concerns about the rule of law and strong US economic data. The last factor is a reminder that a rise in US interest rates, and the accompanying diversion of funds from emerging markets, could outweigh any benefit for Turkey from oil’s slide.
Iran
Tehran was already struggling with the impact of western sanctions imposed over its nuclear programme before oil began to fall. The government of Hassan Rouhani is seeking to rebalance the economy to reduce its dependence on oil in next year’s $93.6bn budget from around 50 per cent to closer to one-third — which would be the lowest in decades. With no prospect of oil prices going up in the near future there is added pressure to strike a nuclear deal before the June deadline. US banking sanctions have cost Iran half its oil revenues. But an agreement could potentially allow Iran, which holds the world’s fourth largest reserves, to sell more crude and have access to about $100bn of foreign exchange reserves which it has been barred from accessing. Failure could lead to a shrinking of the economy and social unrest.
Further Reading: Weak Iran economy adds to pressure on leaders over nuclear deal
Saudi Arabia
Fiscal buffers are in place to offset the impact of any potential domestic deficit but Saudi Arabia — the world’s largest exporter — will still be among the Gulf nations most affected by lower oil prices. At $60 a barrel the kingdom, whose oil receipts accounted for 85 per cent of exports and 90 per cent of fiscal revenue in 2013, would experience a fiscal deficit equivalent to 14 per cent of GDP in 2015, according to Moody’s. Its vast foreign exchange reserves, estimated at close to $740bn, will offset some of the negative effects of much lower oil prices, but such a stressed scenario is still likely to mean a pullback in spending on social programmes which had increased substantially following unrest related to the Arab uprising. Even so, Riyadh has used its leading position in Opec to resist calls for a production cut.
Further reading: For Saudi Arabia, plunging oil prices are a political weapon
Japan
Japan is a clear winner from falling crude. In the last fiscal year to March 2014, the energy-poor nation spent Y28.4tn ($236bn) on mineral fuels, of which more than 90 per cent was linked to oil. Every 10 per cent drop in the price of a barrel represents a dividend of about Y2.6tn. And a 30 per cent drop hands back about as much cash as was raised by the government this year, when it put upconsumption tax by 3 percentage points. In effect, a narrowing in the country’s budget deficit has been “totally paid for, from abroad”, says Hideo Hayakawa, a former chief economist at the Bank of Japan. But lower oil is a mixed blessing for the BoJ, as it could make it more difficult to achieve its 2 per cent target for inflation.
China
China benefits less than might be expected from falling oil prices despite being the world’s largest oil importer. That is partly because the heavy reliance on coal means most of the economy is exposed to oil prices through the transport sector. Diesel and petrol prices, set by the state, stop closely tracking oil prices at around $80 a barrel. That’s good news for state-owned oil refiners CNPC andSinopec, but less so for businesses and drivers. China’s policy banks are also heavily exposed to major oil exporters including Venezuela, leaving Beijing vulnerable when falling prices hit those countries’ ability to repay loans.
Further Reading: Oil price slide a mixed blessing for China
India
Heavily dependent on imported oil and beset for years by fiscal deficits and high inflation, India is an unambiguous beneficiary of lower oil prices. By October, the cost of oil imports had already fallen to $164bn over the previous 12-month period, from a peak of $169bn in July, and that bill will shrink further. Narendra Modi’s government has used the opportunity to abandon diesel subsidies for motorists and raise taxes on both petrol and diesel. The oil price fall cuts the trade, current account and fiscal deficits, while the oil-assisted drop in inflation — down to 4.4 per cent in November — should lead to lower interest rates and a boost for investment. Nor does India suffer so badly from some of the negative factors that will hit fellow Brics such as Russia: commodities, mostly oil, account for more than half of India’s imports and only 9 per cent of its exports, mostly food.
Nigeria
Nigeria’s emergence as Africa’s largest economy is thanks mostly to rapid growth in services. But the country still depends on oil for more than 60 per cent of state revenues and 90 per cent of export earnings. So there is a storm brewing in Africa’s leading producer. Compounding the turmoil is the escalating Islamist insurgency in parts of the north. Oil production is also down — averaging well below its 2.4m b/d capacity, thanks to industrial scale theft and a lack of investment following five years of legislative paralysis over reforms to the industry. Foreign portfolio investors have taken fright, the government has slashed spending for 2015, the stock market is down 23 per cent on the year to date and the naira has continued to come under pressure since an 8 per cent devaluation last month.
Venezuela
Venezuela is estimated by economists to lose $700m for every dollar drop in the oil price. Even before the latest plunge, there was speculation that the country — where oil accounts for 96 per cent of export revenues — might default. Those fears have intensified in recent weeks. The economy is forecast to shrink by 3 per cent this year, while the population is already struggling with shortages of basic goods and inflation running at more than 63 per cent. President Nicolรกs Maduro has said the fair price of oil is $100 a barrel, but analysts at Ecoanalรญtica, a Caracas-based consultancy, estimate that the country needs a Brent price of above $130 to balance its budget. To cover some of the losses, industry experts say Venezuela needs to ramp up its production of between 2.4m barrels a day and 2.8m b/d. But even in the best of circumstances that would take years to come on stream.
Reporting team: Andres Schipani in Caracas, Kathrin Hille in Moscow, Daniel Dombey in Istanbul, Jude Webber in Mexico City, Najmeh Bozorgmehr in Tehran, Robin Harding in Washington, Ben McLannahan in Tokyo, Lucy Hornby in Beijing, Richard Milne in Stockholm, Victor Mallet in New Delhi, Jeevan Vasagar in Berlin, Christian Oliver in Brussels, William Wallis and Anjli Raval in London.
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