Oil

The fall in the oil price is the biggest thing to happen for six months

By Kit

November 30, 2014

Hamish McRae The Independent 30 November 2014

Every swing in commodity values has winners and losers, but here there are many more winners

The fall in the oil price is big. It is big in terms of the raw numbers, a decline on the Brent reference price from above $115 (£74) a barrel as recently as June, to below $73 on Friday. We are starting to see that feed through to heating oil and the price at the pumps. But more important is the impact it has on the world economy. This is the biggest single thing that has happened in the past six months – and it comes in the nick of time, making the recovery in the developed world much more secure. Whenever there is a big swing in prices there are winners and losers, but the winners far outnumber the losers.

The basic point here is that high energy prices are like a tax on global growth. The oil price affects all energy prices and the more money that flows to the producers, the less there is in the consuming nations to spend on other goods and services.

Demand for these is lower than it otherwise would be, and growth, accordingly, is also lower. Indeed one of the reasons, not the only one of course, why the recovery has been more muted than in previous cycles, has been that we have not received the boost to growth that lower energy prices normally provide.

In most recessions, lower output has led to a fall in demand for energy, which has cut the price of it. That did not happen last time around, largely because demand for energy in China continued to rise. It has just passed the United States as the world’s largest oil importer. But now we have had a fall in the price of oil, driven not by a decline in demand but rather by an increase in supply, particularly from the US – hence the boost to growth.

Most people expected that Opec would cut production from its supposed limit of 30 million barrels a day. In the past, the response of the oil cartel has been to reduce supply when the price is weak and increase it when it is strong. Opec members do not want too high a price as that encourages diversification away from oil and the development of oil that had, hitherto, been too expensive to extract. Last week Opec decided to maintain production and you can see from the price fall quite what a surprise this was.

We don’t know the reasoning. It must have been partly because of the difficulty in getting agreement among its very diverse membership, but may also have been to put pressure on higher-cost producers, including those involved in the US shale oil boom. What we do know is that it will also put great pressure on a number of national governments that need a high oil price to balance their budgets. These include, among Opec members, Venezuela, which was apparently less than thrilled at the decision, and, outside Opec, Russia. It has been calculated that the Russian government needs the oil price at $100 a barrel. I suspect that it is somewhat lower. Still, this level of oil prices is very bad news for Vladimir Putin.

It is also, to a more limited extent, bad news for Her Majesty’s Treasury. North Sea revenues last year were £4.7bn. That is less than 1 per cent of the tax take, so they are not really material. But they will be lower this year, and any decline in revenue doesn’t help a cash-strapped chancellor.

For the rest of us, however, lower oil prices are thoroughly good news. A fall in the oil price brings down all prices, thereby increasing real wages. We feel it immediately at the pumps. But gradually it feeds through the production and distribution chains. All energy becomes cheaper, fertiliser becomes cheaper so food becomes cheaper, holidays become cheaper – and so on. We get our higher living standards, but more as a result of lower prices than larger incomes.

How big is the impact? It is hard to know because you have to make a string of rather hairy assumptions about the linkages in the world economy. If the economists cannot get their growth forecasts right a few months ahead, how can they hope to trace through a sequence that will take at least a couple of years before the full effect has moved through the system? But a calculation by the International Monetary Fund suggested that a price fall of 20 per cent would add 0.5 per cent to global growth over the next year. Well, we have had a bigger fall than that, and the impact is huge because it is acting on such a large base. Think in terms of another 50 or 100 million people in work around the world. There are social benefits as well as economic ones.

And the possibility that lower energy prices might tip places where inflation is very low into deflation? That is a profound worry in Europe, and we will hear a lot more about it in the next month or so. In headline terms, the fall in the oil price would appear to make matters worse. But European real wages get a boost from cheaper energy too, and the prospect of European deflation was entrenched long before the oil price plunged.