Oil shock and global economy

S P SETH

There was a time, not long ago, when many people worried about oil, the black gold that was making its producers very rich and important players on the global economic and political stage. And the worry was centred on two factors. First was the rising price of oil---remember the seventies and eighties--- that was creating a lot of uncertainties about economic growth and causing inflation. And the second was constant speculation about finite oil production and reserves and that, sooner or later, the fuel that kept economic wheels turning might run out.

Well, that was then. Today, the oil price has fallen sharply and some expect it to fall further. The question is: what has caused the oil price to plummet so low as it has serious economic and geopolitical consequences? There are several reasons for this. As concerns grew about the likely imbalance between global supply of oil and its growing demand, two things happened. First, major global economies introduced practices to increase oil efficiency in its use, thus putting some restraint on their ever-growing demand for oil. Second, the hike in oil price made it cost-effective to bring into production some old oil wells but, more importantly, to extract oil and gas from shale and tar sands thus creating a glut in the market, with supply overtaking demand for oil in international market.

At the same time, the global economies have still not quite recovered from the 2007-08 recession; thus their growth rate, where positive, is still patchy. And on top of it, the relatively slower economic growth in China has seriously dampened the demand for oil and other resources. Normally, the geopolitical turmoil in some regions of the world, particularly in the Middle East, should work to spike oil price but it is not doing its job when there is already glut in the oil market, estimated at anywhere between one and two million barrels a day. Besides, the demand from building up inventories against any future crisis seems to have dried up for the time being. And with the lifting of sanctions on Iran for fulfilling its part of the nuclear deal, it will soon be entering the international oil market, which is likely to further depress oil prices. It is likely to add another half a million barrel a day into the market.

In the past, the oil cartel of the Organization of Petroleum Exporting Countries (OPEC) used to exercise its leverage by limiting oil supply and hiking the price. But Saudi Arabia, the biggest oil producer, hasn’t seen it fit to do that. Even though the fall in oil price is hurting its revenues, it has enough staying power with large foreign currency reserves, and investments. But the falling price will hit Iran when it is hoping to ease its economic situation. At the same time, Saudi Arabia doesn’t want to lose its share of the global market by limiting supply. And by keeping the price low it wants to drive out producers and investors drawn into new oil production by the higher price of oil not long ago. The low price will make oil production from new wells, and from shale and tar sands, uneconomic. There are already reports that these investments are under debt stress.

The precipitous fall in oil price is causing havoc with economies of some the countries that are heavily dependent on oil exports. These countries include Russia, already subject to economic sanctions from EU and the US, oil producing Middle Eastern countries, including Saudi Arabia with its revenues from oil falling that will make it difficult to bribe its population with all sorts of subsidies, Venezuela with its economy already teetering on the edge, and oil producing countries in Africa like Nigeria and Angola. Here in Australia, emerging as a large producer of LNG, the fall in oil prices, compounded by shrinking demand from China for its iron ore, coal and other resources, the economic situation is creating great uncertainty. Already, the stock market tumbles have reportedly wiped off $ 110 billion from its markets. Canada, another resource rich country, is affected, as well as Brazil and South Africa. Some of China’s African ventures, where it has invested in oil extraction and other mining projects, might already look dubious.

The combination of all these factors is creating conditions that might bring about another global recession, even before the one in 2007-08 has worked its way through. Indeed, the Royal Bank of Scotland has advised its clients to: “Sell everything except high quality bonds.” Because: “In a crowded hall, exit doors are small.” As one commentator has said, pointing to all round confusion, “It is not just economics, but game theory” that is driving the market. “The Saudis”, for instance, “are quite happy to see US shale oil prices not make money, and also some other high-cost producers.”

In the old conventional sense, such big falls in oil price should perk up economies, as oil is a significant component of cost in manufacturing and transport operations. With the expected follow on savings to consumers, they should ordinarily feel encouraged to spend more, but this is not working.  The International Monetary Fund (IMF) has downgraded its predictions for global growth for 2016 and 2017. In any case, it appears that the substantial fall in oil prices is not being passed on to the consumers. At the same time, the character of the global economy has changed since the seventies and eighties. At the time, because of the dominance of manufacturing and its overwhelming dependence on oil and coal, these energy sources were the linchpin of economic growth. The oil price shocks of the seventies and eighties forced a drastic reorganization of the heavy industry to foster energy efficiency. And now with digital revolution and growth of services sector, there is no more talk of running out of oil and its reserves.

Besides, in the light of global warming and emphasis on renewable energy, oil is less prized, though it is still an important component of driving growth in developing countries. It is, therefore, not surprising that the price of oil is in a bit of strife. And unless it works its way through, the global economy is in for a bumpy ride. 

Note: This article was first published in the Daily Times.