The Economic of Low Oil Prices

Oil prices recently hit $27.56 a barrel, their lowest level since 2003. The result is that it is now cheaper to buy a litre of gasoline in your local gasoline station than a litre of sparkling water. But the impacts of the price rout over the last 15 months looks very different depending on your view. For oil importers such as Germany it is great thing but if you are an export land like Nigeria or an equity or debt holder in an oil company you may have a very different opinion. This however is a very simplicity view because the reality is that oil is the most important commodity in the world and the prices of other commodities such as natural gas are very much dependent on it.

Oil is so important for the world economy that it has started major crises, and each time we have seen sudden prices increases in the last decades – in 1973, 1979, 1990 and 2008 – the repercussions have been a global recession. Now there is talk of oil causing another recession but this time it is because of falling not rising oil prices. The theory is that the low oil price will have an adverse impact on investor confidence and bank lending given the significant exposure the financial sector has to the oil sector. This is turn will have a negative impact on capital spending, and ultimately the job market and the consumer. That all said, we have actually seen strong growth in oil demand in 2015, some 1.8m barrels a day.

To make matter more complex, any weakening of the world economy could cause oil demand to decline which could further depress the oil price which in turn would put us into a negative spiral of falling oil prices, business restructuring and decreasing investor and consumer confidence. This would of course not be good for oil producing countries such as the United States and the United Kingdom but each of these countries have the advantage that they are not overly dependent on the oil and gas industry. This in contrast to countries such as Venezuela and Russia which are highly dependent on oil and are already suffering from weak pricing in other commodity markets.

In addition there is another effect and that is that oil is traded in US dollars and thus any price falls lead to declines in the value of exporter currencies (say Brazil or Russia) which means that the oil worker’s salary in dollar terms has collapsed with the oil price. This enables the oil industries in such countries to lower production costs but it has a disastrous impact on the buying power of those workers, noting that the 75% fall in the price of oil since October 2011 has led to a 40% fall in the Brazilian reais and 30% fall in the Russian ruble. Furthermore, a large part of investment in many of these emerging economies are linked to mining, agriculture and oil & gas. Unsurprisingly, there are many oil export countries in recession.

Thankfully, there are only two oil exporters, Russia and Brazil, in the top ten of world economies. All of the rest, US, China, Japan, Germany, UK, France, Italy and India are oil importers. And the good news is that even in the United States, with its big oil industry, we are seeing no signs of recession. In fact, last year, US automobile sales hit an all-time high of 17.5m. We are though seeing job losses in the oil and gas industry but despite that US labor force participation rates remain very high and we are seeing unemployment levels (5%) at the lowest levels since April 2008. In addition, wage increases are accelerating, up to 2.5% in 2015, from 1.7% the year before that. Finally, the deflationary impact of the oil price fall means that we are likely to continue seeing central bankers continuing to push cheap money onto the market and in fact the European Central Bank and the Bank of England have already signalled that, and we recently saw the Bank of Japan unexpectedly step up monetary stimulus.

The bottom line is that oil will not cause a global recession and in fact it may be of huge benefit to the Chinese economy which is going through a transition period. It also could be a great spur for the most dynamic economy in Asia India which grew at a massive 8.4% last year! What’s more, we are seeing solid growth in the United States as well as stability in Europe and Japan. That said, the concern has to be the volatility in the oil price. It is neither good for the producer or the consumer and it pushes investors away. What we need is to see supply come out of the global oil market and for an oil price “bottom” to be reached. If we get that the new world of low oil prices could really spur the global economy forward. But if it does not happen and volatility remains and countries begin to “bailout” their ailing oil industry then we could be in for a nasty global recession.