The global implications of falling oil prices are largely positive – but that doesn’t mean that there aren’t some risks, too
Everyone
is busy celebrating collapsing oil prices, and the huge positives this
will bring to the global economy. From mid-June, prices are down by more
than 40 per cent, with Brent now falling to below $65 a barrel. There
are many highly credible commentators calling for a continued price
spiral, with price forecasts of $50-55 a barrel by mid-2015 not
uncommon. Where prices ultimately settle and for how long is obviously
anyone’s guess, but this is a huge move with global implications both
politically and economically. Is such a large move in so short a time
unambiguously positive for the global economy, as almost everyone seems
to believe? Is it a massive tax cut and more or less a free lunch as
most want to believe?
The decline in oil prices is simply a
transfer of purchasing power from the producer of oil to its consumer.
From the global economy perspective, there is no additional wealth
created
The obvious positive is that this transfer of wealth
from the oil producers to the consumers/importers should lead to a boost
in consumption. A $40-a-barrel decline in prices will lead to a
transfer of $1.3 trillion a year. It is widely accepted that this will
lead to a boost in global gross domestic product (GDP), as the
propensity of the oil importer to consume is greater than the propensity
of the oil producer to spend.
Markets also cheer as the
importers are the European Union, Japan, China, India and even the
United States, all far more relevant for global financial markets than
Russia, Venezuela, Iran or Nigeria (the worst hit by the decline in
prices). While this is a short-term positive for global growth, as
consumers spend and consumption accelerates it will imply a decline in
global savings, which may have longer-term consequences on financial
markets and interest rates. Ultimately, the oil producers were not just
sitting on their oil revenues, they were invested in some financial
asset, somewhere in the world. This investment will stop as consumption
picks up. There are other implications on global financial markets, not
all of which are positive. As the folks at Gavekal point out, nobody
seems to be thinking of the inventory and liquidity effects of such a
steep decline in oil prices. Assume the world consumes about 92 million
barrels of oil daily and carries about 100 days of inventory. When oil
was trading at $100, $920 billion was stuck in inventories, held by
someone in the system and financed by someone else. If the price of oil
settles at $60, the financing needs will drop to $552 billion. Almost
$400 billion of liquidity will get released into the global system. This
is a positive and will only add to the excess liquidity sloshing around
global financial markets. Such a capital release can fundamentally
alter the economics of many players in the value chain.
However,
somebody will also have to take the near $400-billion loss on existing
inventories as prices for all end products adjust immediately. Some of
the inventories will be held in sovereign strategic reserves, and these
losses will be absorbed or camouflaged in national accounts. However,
there will be collateral damage to the whole petroleum value chain, and
somebody will be on the hook for these inventory losses. It is not clear
where the losses will surface, and the absorptive capacity of the
losers. One cannot rule out some nasty surprises. During the last big
decline in oil prices, starting in 1985, large parts of the Texas
banking system went under, and it was also arguably a catalyst for the
eventual demise of the Soviet Union. Losses of $400 billion can stress
any financial system or counterparty.
Over the past few years,
we have seen a massive buildout of non-Organization of the Petroleum
Exporting Countries oil production capacity, largely in shale and tar
sands in North America. Many of these assets are unviable below $60-65 a
barrel, and the question then becomes: how was this rapid production
build-out financed? Clearly, the producers were not generating
sufficient cash flow to self- finance the production/drilling surge. It
was debt – either high-yield bonds or bank lending – that has financed
the majority of the infrastructure needed to sustain the production
surge we have seen in North America over the past five years. But at $60
oil, much of this debt can no longer be serviced.
This has
already thrown the high-yield market into a bit of a tizzy, as energy
was the highest share of the market and spreads for energy issuers have
surged. Most players in the sector have no ability to access new
high-yield issuance. If losses are significant, it may impact access to
high-yield debt for all sectors of the economy. At a minimum high-yield
spreads will rise. Either way, either access or cost of debt will be
negatively impacted for many sectors of the global economy that need
capital the most.
If banks are left holding the can, the
problems may be even bigger. The losses incurred by the banks on this
lending could erode their capital base and earnings power, further
weakening their ability and willingness to lend. If banks do not want to
lend, that has obvious implications for the pace and sustainability of
any economic upturn.
The other obvious negative of declining oil
prices is the impact it has on the relative attractiveness of
alternative energy and renewables. It will make the world economy more
carbon-intensive and less energy-efficient. Just when solar was nearly
at grid parity, the bar has moved downwards.
In a world fighting
deflation, lower oil prices do not really help the central banks. By
putting downward pressure on headline inflation, already low inflation
expectations may get further entrenched or blindside the central banks
to any pick-up in underlying inflationary pressures.
The simple
point is that there is no free lunch, and one should not ignore the
negative repercussions of such a sharp and quick move in a critical
global commodity. There will be both losers and gainers, and it is
important to think this through and not be caught with the losers.
(Source: Business Standard dated 12-12-2014)
