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Monday, February 02, 2015

The economics of falling oil prices 
India should use the opportunity presented by cheap oil to spur growth and dismantle energy subsidies
$40 marked the Global Financial Crisis low in Brent crude oil, which makes it an important support level.
Photo: Frobes
1 February, 2015: Global oil prices hovering below $50 per barrel is not a surprise. The surprise is how long oil prices stayed above $100. The decline, at long last, is good news for the world economy and India. International Monetary Fund (IMF) simulations suggest this will directly boost world growth by up to 0.7% and more for big oil importers such as India. Low oil prices also provide an opportunity for governments around the world to lower interest rates—spurring investment—and phase out harmful energy subsidies that amount to over $600 billion per year. More growth should follow that. 

The winners from lower oil prices are spread widely, the losers are concentrated and more vocal for it, shading the mood. There will be dislocation to the economies of big oil exporters beyond what we have already seen in Russia, Venezuela and Nigeria. Also affected will be oil companies and stock markets heavily weighted to oil and oil service companies and to those that sell what the oil exporters spend their $1 trillion of oil export revenues on. This is not just homes in Kensington and cars built in Munich, but also, and perhaps particularly for the likes of Indonesia, Nigeria and Algeria, the products sold to them by India’s manufacturers and service providers. 

But don’t let that shove the good news behind a bushel. Some fret that lower oil prices signal a slowdown in economic growth in general and particularly in China where growth has decelerated to its slowest pace in 24 years—7.4%. This last statistic is pretty meaningless. After 24 years of 10% annual growth rates, the additional gross domestic product (GDP) created from an economy that has slowed to a growth rate of 7.4% is seven times greater than that of the same economy growing at 10% 24 years earlier. Even a slowing China imported seven million barrels of oil per day in 2014, more than the US and 30 times more than it imported 24 years ago. 

There are demand factors weighing on oil prices but they are structural, not born of the economic cycle. Although the US economy was 10% larger in 2013 than in 2005, consumption of petrol, diesel, jet fuel and other refined products was down 12%. The best solution to high oil prices is often high oil prices, meaning that expensive oil is a strong incentive to conserve. But there were a raft of other incentives too. The US Energy Policy Acts, and the Energy Independence and Security Act, 2007, were among the many initiatives around the world after 2004 that intended to promote conservation. Fuel economy standards for vehicles were raised, ethanol blending targets increased and much more. Lower oil prices may relax the pressure to find further efficiencies, but past gains are seldom reversed. 

Those surprised by the drop in oil prices believed two things: the shale revolution would be stifled by environmental concerns and the Middle East was burning itself down. Often these beliefs served other causes, but whatever the motive of their proponents, the reality was different. The quadrupling of oil prices between 2002 and 2012 financed technological improvements in downhole steering and telemetry that paved the way for the shale revolution. In 2005, fewer than 150 oil wells were drilled into the Bakken formation beneath North Dakota. Last year it was over 2,000. Shale oil production surged from 2,500 barrels of oil per day in 2005 to approximately one million at the end of 2014. Today, shale represents 5% of total oil consumption. 

Shale oil still only makes commercial sense when oil prices are north of $30 per barrel and in some places, north of $75. What kept oil prices high and US shale production in business and feeding their Congressional lobbyists, was concern that tensions in the Middle East would stifle production or reduce certainty of supply. In the first half of 2014, cable news and newspapers were filled with stories of Libya disintegrating and the Islamic State running amok in the oil fields of Iraq and Syria. These concerns prompted financial investors to build long positions in Brent and West Texas Intermediate oil futures contracts equivalent to 650 million barrels of oil. 

This story was laid bare on 22 June when two supertankers loaded 1.3 million barrels of crude at the port of Tobruk in eastern Libya. Libya’s production, which had dropped from 1.8 million barrels per day to just 250,000 by May, rebounded to 900,000 by August. Elsewhere, the Islamic State proved better at winning airtime than oil wells. As oil prices slipped, investors bailed, accelerating price declines. By September, 60% of the net long positions in oil futures had disappeared. 

Financial markets overestimated the challenges to oil supply, prolonging unsustainable prices. Their capitulation made oil prices slump almost overnight to where they should have been. Today, financial markets are misreading the decline as a symptom of Saudi Arabian stubbornness and worries over the world economy. Consequently, the strength of the world economy will surprise on the upside. Politicians will grow impatient, but policymakers should hold their nerve and not be frightened into anything rash. India’s annual oil import bill will probably fall by $40 billion or more in 2015 which should deliver more growth, less inflation and a healthier fiscal position. The government should let part of this dividend provide a temporary boost to consumption and investment and let part of it offset a permanent dismantling of energy subsidies. 

Avinash Persaud is non-resident senior fellow of the Peterson Institute for International Economics in Washington and non-executive chairman of Elara Capital.
Courtesy: Live Mint
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