Sunday, December 14, 2014
Relax: lower oil prices will be good for growth
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Rejoice. That is my normal response to lower oil prices. Filling up the car ranks second only to paying gas and electricity bills as the kind of spending you would rather not do. Anything that brings down the cost of such spending has to be good news.

The average price of a litre of petrol has dropped below 120p a litre, compared with more than 131p in the summer, with a similar reduction in the price of diesel. Had the reduction so far been achieved through cuts in excise duty, the cost would have been £6bn.

With the oil price having fallen by more than 40% to under $65 a barrel, and with analysts predicting that petrol could drop to just over £1 a litre, there should be more of this to come. By the time the process is done, consumers will be benefiting from the equivalent of a tax cut of £10-15bn, much more than in any recent budget.

That is not the only effect. Falling oil prices are cutting industry’s costs. In the past 12 months raw material and fuel costs have fallen by 8.4%, driven by the fall in oil prices. Cheaper oil is cutting inflation directly – it is now just over 1% - and will keep it low in coming months as these very weak pipeline pressures (no pun intended) feed through to energy bills and the price of goods in the shops.

Lower oil prices are helping narrow Britain’s trade deficit, which in October fell to £2bn, half its level a year earlier. Britain is a net oil importer, and has been for many years.

The drop in the cost of crude will also boost the global economy. Oxford Economics, which has a global economic model to estimate the effects of oil price changes, estimates that every $20 a barrel fall in the crude oil price boosts global growth by 0.3 to 0.4 percentage points, sustained over several years.

The benefits are heavily skewed to oil consuming nations. Growth in the Organisation of Petroleum Exporting Countries (Opec) is reduced by around 0.7 percentage points a year by the effect of a $20 oil price fall.

For Britain, according to the Oxford simulations, growth will average 2.6% a year in 2015-16 if oil averages $84 a barrel, but close to 3% if it comes down to $40, which many in the industry are talking about (with some talking about even lower prices). Cheap oil is a growth booster.

As Rob Wood, UK economist at Berenberg, the bank, puts it: “What a Christmas present. Thank you oil men of Dakota. Cheap oil, cheap food, and cheap money give us all the reasons we need to forecast continued strong UK growth and low inflation. We cannot know how permanent the fall in oil prices will prove to be but the further Brent falls, and the longer it stays low, the bigger the upside risks to UK growth in 2015 become.”

So why is there a sense of nervousness about the plunge in the oil price, a worry that it may be not such good news? Why did the FTSE-100 fall by 2.5% on Friday, and 6.6% in the past week?

Some people – including Scottish Nationalists – still see Britain’s North Sea oil as a huge cash cow that pays for public services and will be hard hit. That horse had already bolted, even before the latest fall in oil prices and well before the Scottish independence referendum in September.

The Office for Budget Responsibility noted in its latest assessment, published alongside the autumn statement, that North Sea revenues have dropped by 75% to £2.8bn a year since 2008, on the back of a 50% drop in production and tax changes that allow oil companies to offset more of their capital spending against tax. A lower oil price may knock a few hundred million more off North Sea revenues but that is small beer when set against the benefits.

As it is, the Nationalists’ economic case for independence has been further undermined. Nicola Sturgeon, the Scottish first minister, stands out among political leaders – with the possible exception of the Greens – in praying for the oil price to go back above $100 a barrel.

What are the other fears? The last time oil prices fell this fast, culminating in a drop to just over $30 a barrel (from a high of $147) was in 2008, when the banks were in meltdown and the global economy falling off a cliff. Some argue that if the oil price is a proxy for the strength of the global economy, in which case it is looking like a seven-stone weakling.

No. The oil price does partly reflect weaker demand but most of that is a combination of greater efficient in energy use in the West, coupled with a slowdown in emerging economy growth – including China – from the turbocharged rates of the 2000s. Most of the price fall, of course, reflects greater supply; America’s shale oil and gas revolution coupled with Saudi Arabia’s refusal to perform its traditional role as Opec swing producer by slashing output.

The International Energy Agency, in its latest oil market report, released on Friday, noted that non-Opec supply has risen at a record rate this year and predicts a continued supply surplus in 2015.

Should we worry that the fall in the oil price will batter the budgets of oil producers to the extent that it leads to instability, not just in the Middle East but in countries such as Venezuela and Russia? I think we should limit such concerns. The oil price did not rise above $40 a barrel on a sustained basis until 2004. These countries have enjoyed a 10-year bonanza on the back of an oil price that has usually been well over $100 a barrel. If they squandered it, more fool them. We should also not shed too many crocodile tears for the oil companies.

What about the spectre of deflation? Will not a falling oil price push many countries, and perhaps even the eurozone as a whole, into outright deflation? It might. A $40 a barrel oil price would, according to Oxford Economics, push 21 of the 45 economies it monitors into deflation next year, including many members of the eurozone and the eurozone itself, and Britain.

There is, however, good and bad deflation. Falling prices as a result of domestic deflation are bad. Falling prices as a result of a correction in global energy prices are good, because they boost real income growth.

The oil price, remember, has come part of the way back down to earth but remains significantly higher than it was. We did not pay more than £1 a litre for petrol and diesel in Britain until the autumn of 2007. The fall in prices is a relief, and a welcome boost. Enjoy it for that.