UK: Oil At $30

Are low oil prices hitting global growth? At first glance such a statement seems nonsensical.

A fall in the oil price transfers money from oil-producing nations to oil-consuming nations. Countries which are net oil importers account for about 90% of global GDP and consumers in these countries tend to spend the windfall from cheap fuel prices. Cheap oil should boost world growth, even if it is bad news for the major oil exporting nations. History shows that the reverse holds too. The big spikes in the oil price, in 1974, 1979, 1990 and 2007, preceded major slowdowns in the world economy.

So with the price of a barrel of Brent crude below $30, its lowest level in 12 years and down from a peak of $145, why isn't the global economy in better shape?

For us the shortfall in global growth has not got much to do with low oil prices. Global growth has disappointed because of China's slowdown and the fact that growth rates in the West are stuck at about 80% of pre-crisis levels. China and the rich nations of the West are winners from lower oil prices. Oil-dependent economies like Saudi Arabia or Russia have too small a weight in the world economy to have much impact on global growth.

Agreed, falling oil prices do exert some dampening effects on growth. Activity has slumped in oil-dependent nations. Shares in oil companies have fallen sharply. Last week the ratings agency Moody's identified 175 energy and mining companies that are at risk of ratings downgrades following the fall in the oil and other commodities markets. Exploration and investment have been curtailed with oil companies shelving $400 billion of planned investment since 2014. Tens of thousands of people in the industry are being laid off.

The crisis has rippled through to suppliers and the financial sector. Banks are making greater provisions for losses on loans in the energy sector. By stoking financial stress the bursting of the oil bubble has the potential to erode wider growth prospects, just as the bursting of the dotcom bubble did in 2000.

Yet overall the lower oil price looks like a positive for global growth. Falling prices have bolstered consumption in the West, much as conventional wisdom would suggest. Consumer spending in the US, Japan, the euro area and the UK has picked up in the last 18 months.

Nor should we see falling oil prices as signalling a collapse in activity. Global demand for oil has grown in the last three years, and is likely to do so again this year. The reason prices are falling is that too much oil is being produced.

The US fracking revolution has transformed global oil supply. Average US monthly crude production almost doubled between 2008 and 2015 lifting America's share of global production from 10% to 16%.  Saudi Arabia, long seen as the world's most important oil producer, accounts for 10% of world production.

For the last 40 years OPEC, the Organisation of Oil Exporting Countries, has been the arbiter of oil supply and prices. Yet faced with a surge in US production the OPEC nations, led by Saudi Arabia, have maintained their output to safeguard their market share. The recent lifting of sanctions on Iran will add, still further, to supply.

Fracking has shifted the global supply curve for oil to the right. With demand little changed, and the power and willingness of OPEC to limit supply waning, the result is a lower equilibrium price. While lower oil prices have hit investment and exploration, they have so far had surprisingly little effect on supply, especially from North America. For many producers it is better financially to keep on pumping oil at $30 than close up and write off investments and future returns.

In the long term the political effects of a lower oil price are as potentially as significant as the economic effects.

Saudi Arabia, which is running a budget deficit equivalent to 15% of GDP, has responded to the shortfall in revenues by announcing radical cuts to public spending and subsidies, and a wave of privatisations. Venezuela has the world's biggest proven oil reserves. But without large currency reserves, and following years of economic mismanagement, the economy is desperately vulnerable to lower oil prices and is experiencing its worst recession in over 70 years.

But perhaps the biggest loser from low oil prices has been Russia. Oil and gas account for 70% of Russian export incomes. Coupled with Western sanctions over Russia's involvement in Ukraine, the Russian economy has been hit hard. After a 4.0% contraction in 2015 the Russian economy is forecast to shrink by 0.4% this year. Russia's government has said it will cut spending by 10% in response to the most recent fall in oil prices.

In time a lower oil price could limit the geopolitical ambitions and capacity of powerful, oil-dependent states including Russia, Iran and Saudi Arabia. Reduced American dependence on Middle Eastern oil may reduce its involvement in the region.

The oil price may well yet drift lower still. But we should beware of the tendency, at extremes in asset prices, to extrapolate recent trends into the indefinite future. At the end of the last, long downturn in oil prices, in 1999, The Economist's cover story, "Drowning in oil" speculated on the price dropping to $5. That marked the beginning of a long upswing in prices. When the oil price reached its peak, of $144, the talk was of how declining reserves and endless demand from China meant permanently high prices. The commodity cycle is not dead, it is in the down phase.

Low oil prices are already hitting exploration and investment. In time, output will respond and prices will start to head higher. But for now, that day looks some way off. The North American fracking revolution and weaker OPEC pricing discipline constitute two massive supply shocks. Cheap oil is likely to be around for some time yet.

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