Oil prices have plunged by more than 40 percent in the last six months and if they go below $60 a barrel, and they should, they will register the lowest price since 2009. What are the oil prices telling us with this violent behavior? Is there a global demand problem or a global supply problem?
Each has different implications for the world economy and OPEC’s ability to manage the price. If it is a supply question, then it is the result of the shale revolution and the refusal of the Saudis to cut production for reasons I explained in previous articles.
In this case, we can assume that the global economy is healthy and it should not hide any negative surprises. We know that the demand side works slowly on prices, while the supply side can have negative and
positive surprises.
The International Monetary Fund (IMF) has attributed the oil price plunge mainly to causes happening on the supply side. The ratio is close to 80 percent for the supply side causes, while 20 percent goes to causes that have to do with demand. This implies the global economic growth is not the major cause behind the oil price plunge, according to the IMF.
However, J. P. Morgan has a substantially different ratio balance. It attributes 55 percent to supply side causes and 40 percent to demand causes that include the slowdown in emerging economies.
The J. P. Morgan ratio suggests a slower global economic growth than the IMF ratio does. It also implies that OPEC is in a tougher position to increase oil prices by cutting production which means a consensus on quota allocation among the members is hard to get.
It is much harder to manage oil prices now than before because there are many parts on the supply and demand sides that are moving together. Currently, the bond market seems to have questions about the world’s future economic growth and supports a higher ratio for the demand side.
Both the IMF and J. P. Morgan see the drop in oil prices as a net positive for the world gross domestic product, given their ratios between the supply and demand causes, but the impact will vary among countries. The oil producing countries like Mexico, Venezuela, Iran, Russia, Nigeria, Canada, Australia and all OPEC countries will lose, while major oil-importing countries like India, Japan and eurozone countries will gain.
Mexico is the least affected among the oil exporters because it hedges its oil exports every year, and the current hedge is $85 a barrel. Russia would be the worst loser in the group even if the sanctions and the plunge of the ruble are not accounted for, according to
Oxford Econometrics.
On the other hand, the Philippines among the oil importing countries would witness the biggest boost to its economic growth, according to Oxford Econometrics.
India in particular is a clear winner because oil makes up 5.5 percent of its economy, 37 percent of its total imports and 67 percent of its trade balance. India is now considering hedging its oil imports based on a proposal from the Reserve Bank of India.
The case is more complicated for the U.S. than for other oil-importing countries. The U.S. is the largest global oil consumer, consuming a quarter of world production. It is also becoming one of the largest global oil producers, expected to produce more than 11 million barrels a day, and getting ready to be an oil exporter.
It is also a world leader in producing alternative sources of energy such as solar, wind, biofuel and plug-in cars, etc. Obviously the oil shale producers will be the biggest losers along with the oil service companies.
The very large interlarded oil companies may benefit from the merger frenzy that will follow the plunge of oil prices by acquiring companies that will boost their oil reverses and production. The producers of alternative sources of energy will also suffer. This means jobs in the oil industry will suffer.
The American consumer which makes up about 70 percent of the U.S. economy will benefit. There are estimates that the average household will save in gas consumption $900-$1100 a year if oil prices stay at their current levels.
Households could also save another $900 dollar in heating their houses this winter if the U.S. has a harsh winter. There are signs that these benefits are taking traction among the consumers as the latest figures for retail sales and consumer spending are showing.
However, the consumer is likely to experience a drop in net worth as the oil plunge will spill over to other financial markets, particularity the stock market. But the part of wealth effect due to owning stocks is not as strong as the part due to owning houses because stocks are concentrated in the hands of the wealthy that use the proceeds to add to savings and not to
increase spending.
However, the housing sector should benefit from the 23 percent drop in gasoline prices since last June. This means about an $80-$100 saving each month, which should increase the purchasing power of home buying by 11 percent.
Lower oil prices will also benefit manufacturers, shippers and
energy-intensive firms.
The plunge in the oil price has considerably appreciated the U.S. dollar and depreciated other currencies. The gyrations in the exchange rates should affect credit spreads among countries, which, if they reach a certain level, can lead to defaults and credit crises.
This has an implication in the supply demand ratio, in that it gives a greater weight for the demand side. The appreciation of the U.S. dollar may also have given impetus for the deflation tendency in the United States to continue, which is feared now in this country.
I could not write this article without quoting American journalist Thomas L. Friedman, “sustained low prices for oil and gas would ‘retard’ efforts to sell more climate-friendly, fuel-efficient vehicles that are helped by high oil prices and slow the shift to more climate-friendly electricity generation by wind and solar that is helped by high gas prices.”
Friedman means the environment will be one of the losers in this case.
Shawkat Hammoudeh is an economics professor at Drexel University. He can be contacted at [email protected].