Tuesday, December 2, 2014

The economics of lower oil prices

The price of oil has moved sharply lower over the last 5 months.  This has been the combined result of softening global demand and increased supply (from the US).  One factor that can normally be relied upon to lead to some stabilisation in times of price weakness is production cuts.  However, at its most recent meeting last month, OPEC left production levels unchanged.  This led to a further decline in prices towards the end of the month.  Prices (WTI, USD/bl) are now down close to 40% on the 2014 peak of US$107 per barrel seen in July.

The implications for oil producers are clear.  Lower exports revenues, lower growth and weaker current account balances – although lower currencies are assisting to varying extents.  And of course lower prices makes investment in new production capacity uneconomical.  Indeed some industry commentators are suggesting OPECs decision not to cut production is aimed at making further expansion of US shale oil production uneconomic.

At the global level there are a couple of important economic impacts.  Lower oil prices leaves more income in the hands of consumers to spend on other things – so it’s good for consumption and GDP growth.  And of course lower oil prices means lower inflation and reduced inflation expectations.  Sure many central banks focus on underlying or “core” measures of inflation but persistently low oil prices will also have an impact on core inflation in time.  All else being that means easier monetary conditions than would otherwise be the case.

In the United States, both an important consumer and increasingly important producer of oil, the impact of lower oil prices will be a net positive for the economy as the lower oil revenues and lower capital expenditure. But it also reinforces our view that the risks around a mid-2015 interest rate hike from the Fed is biased to later rather than earlier.

In Japan our concern this year is that the reduction in real incomes on the back of the recent tax hike.  Lower oil prices will provide a welcome offset to that.  But it also makes the Bank of Japan’s 2% inflation target even more challenging that it was already.  Similarly in the Euro zone the problem of already low inflation is exacerbated and makes the intended expansion of the ECB’s balance sheet more urgent.