We look at the potential winners and losers from the recent slide in oil prices.
What connects the last four major global recessions, from the Stagnant Seventies to the mega-crash of 2009? Answer: all were preceded by costlier crude. The opposite is also true. Cheap oil helped fuel the post-war Golden Age and a decade of vigorous growth in the 1990s. With this in mind, a 40% fall in the price of oil since June is one of the most important economic developments this year.
So what caused this collapse? And, if it indeed represents a “new chapter” of cheaper oil, who stands to benefit and who stands to lose?
The sharp fall in oil prices shown below is a result of excess supply meeting softer demand from a slowing world economy. This has been compounded by speculative selling.
Brent crude oil price ($)
Source: TT International, Bloomberg
Since 2010 global real GDP growth has slipped from more than 5% a year to just over 3%. Emerging markets are seeing an unprecedented deceleration due to China’s fading dynamism, a sputtering Eastern Europe and Latin America’s slowdown. Meanwhile, the developed world recovery is far from assured as Europe is battling deflation and Japan is struggling to shake off a demand-sapping consumption tax hike. Soft growth translates into lower energy demand, which is further constrained by a more subtle shift towards conservation and energy saving. For example, the average new car consumes 25% less petrol per mile than ten years ago. Consequently, global oil demand this year is expected to be the weakest since 2009.
This comes at a time when the world’s output of oil is rising rapidly. The US now produces 65% more black gold than it did just 5 years ago thanks to “fracking”, a drilling technology revolution that is liberating oil from shale formations that were previously inaccessible. Output is at its highest level since the mid-1980s. Russian production is also within a whisker of a post-Soviet high, despite painful western sanctions. Adding to the supply glut is a surprising recovery in war-torn Libya's oil production, and near-record Iraqi supplies, even as ISIS forces roll through the country.
Opec, a cartel that supplies 40% of the world’s oil, could curb production to defend prices. But its biggest member is still scarred by a previous attempt at this strategy in the mid-1980s. When Saudi Arabia slashed its output by 75%, other producers failed to follow suit and prices slumped. This led to 16 years of Saudi budget deficits that left the kingdom deeply in debt.
More importantly, Saudi Arabia does not want to concede market share to the US by cutting production. US shale is relatively expensive to extract because it comes from many small, short-lived wells. The Saudis are therefore hoping that by allowing the oil price to languish, many American oilmen will be forced out of business. However, US break-even points are falling as fracking techniques are refined, while hedging strategies have locked in higher prices for a year or two. If the Saudi’s are hoping to sweat out higher-cost competition, they may be waiting for some time.
After a decade of shortage, the world is now awash with oil. Unless production is cut or demand picks up significantly, some 1.4 million barrels more crude oil per day than is actually needed will flood the market next year, placing further downward pressure on prices.
And the winner is…
Slumping oil prices will rapidly create winners and losers. The biggest beneficiary is the global economy itself. This is because resources are shifted from producers to consumers, who are more likely to spend their gains than wealthy sheikhdoms. Consequently, a 40% price slide should boost global GDP by some 0.8%.
The overall benefit may be even greater, given that prices of other commodities are also plummeting as excess supply meets weak demand. That said, if consumers exercise caution in the face of softening economic growth, they may save their windfall rather than spend it, undermining the overall impact on GDP.
Drilling down to a country level, the large net importers of oil stand to gain the most. They include China, Japan and India. These nations help ensure that Asia is the biggest regional beneficiary, with net oil imports at 3.5% of aggregate GDP. More specifically, China’s economy would save almost $100bn annually if the oil price stuck at current levels. Import bills would also come down in Japan and India, as would the latter’s chronically high inflation rate. This should lead to lower interest rates, boosting investment. Additionally, cheaper crude will improve India’s fiscal position by reducing the pain of cutting expensive fuel subsidies. These cost the country over $10bn a year.
Other countries will find falling prices a mixed blessing. Thanks to its shale boom, the US is now the world’s largest oil producer. However, it remains a net importer and will still benefit from the price slump. According to Barclays, $40bn in foregone capital spending by US oil companies will be outweighed by an extra $70bn for consumers to spend. Moreover, cheaper oil may anchor inflation below target, which could persuade the Federal Reserve to keep interest rates lower for longer.
Inflation in the euro zone is even lower than in America. Thus, while the region would save over $100bn a year if oil prices remain subdued, it would also be more likely to slip into deflation. Furthermore, its weakening currency will dampen the positive effects of cheaper oil, which is priced in dollars. This is also true of countries like Japan.
Oil producers: over a barrel
The impact on major oil producers is less ambiguous: falling prices are a crude awakening that will lead to stalling growth and swollen budget deficits. Opec members look particularly vulnerable as their economies are heavily reliant on oil. Petroleum accounts for 70% of their exports, or roughly $1.1tn a year. These earnings will be slashed by over $400bn if crude remains below $70.
However, oil exporters vary widely in their ability to withstand such shocks. Saudi Arabia is currently funding many expensive public infrastructure projects, but it has also amassed $750bn of foreign currency reserves, meaning budget deficits could be sustained for several years. The same can be said of other Gulf producers such as Kuwait and the United Arab Emirates.
Other petro-states have less room for manoeuvre. Iran, Iraq and Nigeria have combined foreign currency reserves of less than $200bn and greater domestic budgetary demands because of their large population sizes in relation to their oil revenues. Iran has the added pressure of a crippling western embargo designed to punish Tehran for its nuclear activities.
Western sanctions are also hurting an already sluggish Russian economy. The country obtains more than half its budget revenue from oil and gas, and its currency is sensitive to oil price changes. If crude remains cheap, there is a substantial risk that the economy will be dragged into recession next year, particularly as consumer incomes are being eroded by a crumbling rouble.
Venezuelan purchasing power is even more under the cosh. The socialist government restricts access to dollars for importers, a disastrous policy in a country that imports three-quarters of the goods it consumes. This has led to severe shortages of basic goods and rampant inflation of over 60%. Declining oil revenues will only exacerbate such shortages. Indeed, dollar income was down 30% in October due to cheaper oil. If this continues, Venezuela’s dollar shortfall will more than double to $27bn next year, prompting more food scarcity, higher inflation and potential social unrest.
Anti-government protests in Venezuela claimed the lives of 41 people earlier this year. More unrest could follow if falling oil revenues exacerbate food shortages. Source: Wikipedia
With slower global growth and increasing US shale supply unlikely to change any time soon, a prolonged period of oil price weakness looks likely. In fact, downward pressure on prices may even intensify as big oil producers such as Russia raise output to offset the damage to their budgets from lost oil revenues. This new chapter of cheaper crude will grievously wound oil producers, but it will also act like a broad tax cut in major oil consuming nations, providing a $1 trillion boon to the world economy.
Nothing in this document constitutes or should be treated as investment advice or an offer to buy or sell any security or other investment. TT is authorised and regulated in the United Kingdom by the Financial Conduct Authority (FCA).