Oil price collapse: is it different this time?

Going down

Noe van Hulst, Ambassador of the Netherlands to the OECD

With oil prices unexpectedly dropping to $30 and their lowest level in dollar terms since 2003, many people are asking what the impact will be on the global economy and on energy markets. It used to be conventional wisdom that a falling oil price puts more money in the pockets of consumers and industry, thus boosting spending and global economic growth. Whereas experts normally differ on the size of this positive economic impact, there seems to be more hesitation about whether even to expect any positive impact for the most recent oil price drop.

Some observers suggest that “this time is different” because somehow the adverse effects on oil-producing countries and firms seems to be greater than the benefits to oil consuming countries and firms. It can certainly be noted that the “losers” of falling oil prices are much more vocal in exposing their pain than the “winners” in welcoming their gains. And of course we all feel empathy for those parts of the population of oil producing countries that are severely hit by welfare and salary cuts.

However, this should not let us lose sight of the bigger macroeconomic picture where it is very hard to imagine anything else than that the positive impact of so much lower oil prices on a broad group of consuming countries and companies outweighs the negative effect on a limited group of producers. In my view it is more likely that it simply takes more time for lower oil prices to “work through the system” and generate the full positive economic impulse on economic growth. This has also been the case in past experience, as some experts have pointed out.

In other words: we are still to harvest more of the economic gains that consumers enjoy. Last summer the IMF estimated the positive effect of lower oil prices on global growth (even allowing for only partial pass-through to retail prices) at around 1/2 percentage point in 2015-16 and the last Economic Outlook of OECD (November 2015) had roughly similar numbers for the OECD area. Since then oil prices have dropped significantly further, so these estimates are on the low end of what we may expect. Obviously, other shocks like the volatility caused by financial turmoil in China may offset this positive effect. But without the oil price fall the economic consequences of these other shocks would have been worse.

Another reason why the oil price decline has a net positive effect on global activity is that oil producing countries don’t reduce spending to the same extent as their revenues shrink because many, including Saudi Arabia, Iran and Russia, built up significant buffers in earlier days. At the same time there are signs that we are seeing oil producing countries adjusting to the new reality of “lower for longer”, meaning oil prices perhaps remaining at relatively low levels for a longer period of time than previously anticipated. An increasing number of them are engaging in fiscal adjustments with magnitude and pace varying according to the size of their buffer, e.g. by reducing fossil fuel subsidies and stepping up efforts to introduce or increase taxes and economic diversification to non-resource sectors. These policy changes are actually very welcome and although in the past similar moves haven’t been very successful, maybe this time is different after all!

One of the key questions is of course how long oil prices will stay so low. Oil producers are slashing investment big time which may indeed cause prices to rebound in 2017, as the IEA expects. But nobody knows to what extent and how fast this reversal will take place and the oil-producing countries now aiming for a “freeze” of production levels seem less able to align their policies than previously. More importantly, U.S. shale oil production operates under a different, much more flexible business model which is demonstrating surprising resilience in the face of the price collapse. That’s why some experts talk about a “new oil order” where U.S. shale oil puts a cap on oil price rallies. In addition, oil is facing increasing competition in the previously captive market of transportation: electric vehicles, natural gas, etc.

A final key question is what impact the oil price fall has on the implementation of more stringent climate policies after COP21. Oil prices in many complex ways also push down other energy prices, which is why we should worry about the weakening of the price incentive to step up energy efficiency in transportation, buildings, industry and households. And we may also see a smaller appetite to boost renewable energy around the world. This last factor may actually be the nastiest consequence of low oil prices. Policy makers should carefully consider how to ringfence their climate policies as much as possible in the sense of making the progress in this area less dependent on the level of oil prices, because oil prices will remain very volatile as history shows!

Useful links

International Energy Agency (IEA) 2016 Medium-Term Oil Market Report

February 2016  OECD Interim Economic Outlook