By Marian Radetzki
December 30, 2014
Several factors are behind the recent oil price developments. All have to do with the forces of supply and demand. (Source: Reuters photo)
After hovering around $110 per barrel from late-2010 till mid-2014, oil prices fell suddenly and unexpectedly in the year’s second half, to reach $60-70 per barrel by December. The earlier price level represented a historic high, explained by a supply troubled by the failures of the Arab Spring, the political disorder in Venezuela and sanctions against Iran for its nuclear policies, all of this while demand growth remained high. But what were the causes of the dramatic price fall and what will its implications be for the world economy and politics?
Several factors are behind the recent oil price developments. All have to do with the forces of supply and demand. Supply has expanded impressively, primarily thanks to the North American shale revolution. The US alone has seen a rise of 70 per cent in crude output, from 5 to 9.5 mbd (thousand barrels per day) between 2008 and 2014. Opec’s members have cheated by exceeding their output ceiling of 30 mbd and the organisation has refused to implement further cuts in support of the price level. Demand has been held back by a combination of restrained economic growth across the world and ripening energy-saving technology, the result of efforts prompted by the earlier high prices.
Oil-exporting countries obviously suffer from falling prices. Government revenues from oil production and exports decline, so the public sector is forced to curtail its vote-winning welfare programmes. Export revenues shrink, so there is less money to buy foreign goods. Falling investments and labour income contribute to the malaise. The scope for mischief by nasty regimes that use oil exports for political ends (Russia and Venezuela are prime examples) is limited when oil is in surplus and prices weaken.
For the oil importers, and India is prominent among them, however, a lower price is an unambiguous benefit. High oil prices function much like a sales tax in the importing economies. A price fall implies a partial removal of the tax, stimulating consumption and economic growth, and lightening the burden on the current account. Christine Lagarde of the IMF has recently asserted that world economic growth next year may be speeded up by 0.2-0.3 per cent if oil prices remain below $70 for some time.
For how long, then, are the recent prices likely to remain? To make a judgement, consider both the forces that shape supply and the main factors that determine demand.
At $60, virtually all global oil production is highly profitable, so there are no economic reasons to motivate a higher level. Many analysts and virtually all media make the fallacious claim that oil prices must go up; a higher price is necessary to bring the public budgets of the oil exporters back into balance. The argument does not make sense. It is akin to saying that the halving of iron ore quotations since 2013 must be reversed, otherwise India will not come to grips with its sizeable budget deficit. Primary commodity prices are set by markets and are unrelated to the budget situations of the exporters.
Prices moved up to $100 and above in past years primarily as a consequence of a capacity-destroying resource curse, with output heavily constricted in Iraq, Libya, Nigeria, the Sudans, Syria and Venezuela, as different domestic factions fought violently among themselves, sometimes with the participation of foreign parties, to appropriate the high rents generated by the oil industry. In the absence of such a destructive resource curse, the global oil production capacity would have been much higher and could easily have prevented the price excesses that actually occurred. Maybe the worst of the curse is behind us, so that capacity growth can proceed in greater peace. This, in turn, would subdue future price rises.
As in the recent past, oil demand developments will be shaped by two preconditions. The first is the global macroeconomy, which has recently hovered close to recession levels. Oil demand will clearly get a boost once recession loses its grip and faster growth occurs. The courses charted by the largest emerging economies, China and India, are of particular significance, since these countries are passing through stages of economic development that are particularly intensive in the use of energy and raw materials. Another factor, however, points to continued restrained demand for some time. As noted, the very high prices of recent years have triggered numerous energy-saving technological breakthroughs, whose impact is only now beginning to be perceived in oil-consumption numbers. There is much more to come, and this will be a suppressive force for global oil demand.
On balance, the forces of supply suggest that the lower prices of the recent past will remain, while the net effect of the factors shaping demand are harder to determine. A plausible bet is that they will balance out, with stagnant demand evolution for the next year or two.
- See more at: http://indianexpress.com/article/opinion/columns/falling-up/99/#sthash.8NfDIjVl.dpuf
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