Much of the current decline in oil price can be explained by recent demand-supply dynamics. Supply has risen sharply due to shale and tar sands oil production coming on line, return of Libyan and Iranian production, and new discoveries in Africa and elsewhere. On the other hand, demand has been constrained primarily by global economic weakness, and less so by increased fuel consumption efficiency.
Here are three less discussed observations on the decline in oil price.
1. There is little to doubt why this time is different with the oil price cycle. History teaches us that oil price spikes are associated with a sharp rise in investments in wells and refineries. These investments take time to come on line, by which time the business cycle reverses, causing a supply glut and declining prices. Since their investment option value is exercised, new producers keep producing so as to cover their variable costs. But falling price in turn boosts consumption and economic output, as well as discourage investments in production capacity (which any ways take time to become operational). The combined effect of increasing demand and stagnant production (and prospects) is a return to rising prices.
All the standard signatures of this dynamics are present in the current cycle. The China-led emerging market boom and pre-recession spike in oil price triggered an investment binge. It made shale and tar sands attractive sources. Businesses invested in sweet crude refining capacity in the US. The Great Recession struck and Chinese economy started showing weakness. Oil price falls by nearly 40% in less than six months. Consumers benefit and it is likely to be a net gain for the world economy as a whole. This sets the stage for increased demand and rising prices...
2. Much has been made out of the dramatic increase in shale oil production in the US and its salutary effect on US manufacturing and the economy. Now that the momentum has turned, the sustainability of the shale oil exploration induced economic growth has become questionable. Apart from the commercial viability of shale oil at these prices (which is highly contentious and very difficult to estimate), new drilling projects and other investments are being scaled back or cancelled. The cumulative impact on US economy could be substantial, even if off-set by the consumer wealth effect and decreased production cost for non-oil businesses. Recent stories about drillers cutting back on rigs is a pointer to a possible reversal.
3. Finally, the falling oil prices present opportunities for emerging economies like India and Indonesia in both lowering current account deficits (CAD) and rolling back their massive energy subsidies. However, in India's case, there are formidable challenges to seizing these opportunities.
Though India has already taken the first step by recently decontrolling diesel price, on top of the earlier decontrol of petrol price, there are doubts about its resolve to hold steady when prices recover. For example, the gains from the decontrol have been offset by the subsequent hike in excise duty on petrol and diesel and the decision to not pass it on to the consumers and let it be borne by the national oil companies. Further, instead of slowly lowering the subsidy by not reducing prices on the face of decline in global price, the government has preferred to pass on the down-side gains to the consumers.
Similarly, hopes of lower CAD may be misplaced. The decline in oil import bill could be more than offset by increased gold (consequent to easing of the import controls) and other imports (as the economic growth picks up). Indeed, the CAD is already showing signs of widening.
Update 1 (10/01/2015)
From Business Standard,
Here are three less discussed observations on the decline in oil price.
1. There is little to doubt why this time is different with the oil price cycle. History teaches us that oil price spikes are associated with a sharp rise in investments in wells and refineries. These investments take time to come on line, by which time the business cycle reverses, causing a supply glut and declining prices. Since their investment option value is exercised, new producers keep producing so as to cover their variable costs. But falling price in turn boosts consumption and economic output, as well as discourage investments in production capacity (which any ways take time to become operational). The combined effect of increasing demand and stagnant production (and prospects) is a return to rising prices.
All the standard signatures of this dynamics are present in the current cycle. The China-led emerging market boom and pre-recession spike in oil price triggered an investment binge. It made shale and tar sands attractive sources. Businesses invested in sweet crude refining capacity in the US. The Great Recession struck and Chinese economy started showing weakness. Oil price falls by nearly 40% in less than six months. Consumers benefit and it is likely to be a net gain for the world economy as a whole. This sets the stage for increased demand and rising prices...
2. Much has been made out of the dramatic increase in shale oil production in the US and its salutary effect on US manufacturing and the economy. Now that the momentum has turned, the sustainability of the shale oil exploration induced economic growth has become questionable. Apart from the commercial viability of shale oil at these prices (which is highly contentious and very difficult to estimate), new drilling projects and other investments are being scaled back or cancelled. The cumulative impact on US economy could be substantial, even if off-set by the consumer wealth effect and decreased production cost for non-oil businesses. Recent stories about drillers cutting back on rigs is a pointer to a possible reversal.
3. Finally, the falling oil prices present opportunities for emerging economies like India and Indonesia in both lowering current account deficits (CAD) and rolling back their massive energy subsidies. However, in India's case, there are formidable challenges to seizing these opportunities.
Though India has already taken the first step by recently decontrolling diesel price, on top of the earlier decontrol of petrol price, there are doubts about its resolve to hold steady when prices recover. For example, the gains from the decontrol have been offset by the subsequent hike in excise duty on petrol and diesel and the decision to not pass it on to the consumers and let it be borne by the national oil companies. Further, instead of slowly lowering the subsidy by not reducing prices on the face of decline in global price, the government has preferred to pass on the down-side gains to the consumers.
Similarly, hopes of lower CAD may be misplaced. The decline in oil import bill could be more than offset by increased gold (consequent to easing of the import controls) and other imports (as the economic growth picks up). Indeed, the CAD is already showing signs of widening.
Update 1 (10/01/2015)
From Business Standard,
According to an analysis of Macquarie Research, lower oil and other global commodity prices bodes well for containing inflationary pressures. A 10% reduction in crude oil prices could reduce CPI inflation by around 20bps and a 30bps increase in GDP growth. A $10/bbl decrease in oil prices reduces India’s import bill and, hence, the current account deficit by $10bn or 0.48% of GDP.
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