Falling Oil Prices

Who are the winners and losers?

During the course of past six months, the global oil prices have fallen sharply. From 2010 until mid-2014, world oil prices had been fairly stable, at around $110 a barrel. But since June 2014 these have almost halved. On January 13, 2015 the price of a barrel of Brent Crude crashed through the psychological barrier of $50. Although commodities like oil constantly go through cycles, thrashing of oil prices in the last few months has been feeding frenzy and alarm as to what will the future hold? The IMF estimates that each $10 a barrel fall in the price lifts world growth by 0.2%, but producers, exploration companies and oil speculators have all suffered.

Why is the price falling?
It is textbook economics: falling demand means rising supply. The oil price is partly determined by actual supply and demand, and partly by expectation. OPEC controls nearly 40% of the world market and its decisions shape expectations: if it curbs supply sharply, it can send prices spiking. A global supply glut, weak demand and a strong dollar have pushed oil prices to five-year lows.  In addition, after the OPEC members failed to reach an agreement on production curbs in its Vienna meeting on November 27th, 2014, the prices tumbled. Conspiracy theorists are also blaming the sharp drop in oil prices as moves against Russia, Iran, Iraq and ISIS.  Iran even came out blaming unnamed countries of plotting to bring down crude prices, saying that the reason behind the fall in oil prices is not entirely economic but also political.

How much further can oil prices fall?
The US government expects that Brent crude will average $68 a barrel in 2015. Some traders are making bets on oil falling to $40 or $30, with a few putting money on $20 — a level not seen since 2002. Stephen Schork, a US-based market analyst, said investor “psychology” is driving oil trading. “We could get a rebound to $70 but we could see $30 before we see $70.”

Simon Redmond, Standard & Poor’s industry specialist for oil and gas in Europe, estimates:

“Our working assumption for next year is for Brent to average $70 and WTI about $65 per barrel. On the one hand, we have a softer demand outlook with weaker figures in Europe and China.

Kash Kamal, an analyst at brokerage Sucden Financial, says :

“Market participants have been looking for a floor, with consolidation around $80, $70/bbl and now $60 a barrel, but with the current fundamental outlook we’ve failed to gain any traction at these levels.”

Michael Barry, consultant at Facts Global Energy, an energy consultancy, puts it in this way:

“On average we see [2015] Brent price at $56 and the WTI at $51.50. Oil prices are likely to fall further to below $50 a barrel or even lower over the course of the first quarter of 2015.”

The Biggest Winners
Overall, the clear winner is the global economy itself. IMF estimates that for every 10 percent change in the price of oil, around 0.2 percent is added to global GDP. Some countries stand to gain a lot more especially those that consume more oil than they produce.

China
China which is now the biggest net oil importer at around 6.6 million barrels of oil per day will gain the most in terms of net savings.  The more than $50 drop in the price of oil since June means that it stands to save $330 million per day, or roughly $120 billion per year, if prices are sustained at these levels.

Nevertheless, the overall impact of the benefits would be less than what is being expected. That is partly because the heavy reliance on coal means most of the economy is exposed to oil prices through the transport sector. Diesel and petrol prices, set by the state, stop closely tracking oil prices at around $80 a barrel. That’s good news for state-owned oil refiners CNPC and Sinopec, but less so for businesses and drivers. China’s policy banks are also heavily exposed to major oil exporters including Venezuela, leaving Beijing vulnerable when falling prices hit those countries’ ability to repay loans.

India
India, the 4th largest net importer of oil, is the most economically sensitive to the price of oil. Oil is 37 percent of India’s total imports and is equivalent to 67 percent of its trade deficit. Being heavily dependent on imported oil and beset for years by fiscal deficits and high inflation, India is an unambiguous beneficiary of lower oil prices. By October, the cost of oil imports had already fallen to $164bn over the previous 12-month period, from a peak of $169bn in July, and that bill will shrink further.

Japan
Japan is a clear winner from falling crude. In the last fiscal year to March 2014, the energy-poor nation spent Y28.4tn ($236bn) on mineral fuels, of which more than 90 per cent was linked to oil. Every 10 per cent drop in the price of a barrel represents a dividend of about Y2.6tn. And a 30 per cent drop hands back about as much cash as was raised by the government this year, when it put up consumption tax by 3 percentage points. In effect, a narrowing in the country’s budget deficit has been “totally paid for, from abroad”.

USA
Falling oil prices may slow down the shale revolution but are still good news for the US economy, as the cash saved on filling up a car swells the wallets of hundreds of millions of consumers. The fall in oil prices so far will provide the US public about $75bn a year to spend on other goods — about 0.7 per cent of total US consumption. Analysts predict a fall in oil investment but Goldman Sachs pegs it at no more than 0.1 per cent of GDP.

Mexico
Mexico is opening up its oil and gas sector to private investment after nearly 80 years of state control. But it stands to see investment squeezed as a consequence of the oil price plunge. Companies vying for the chance to drill $100m wells say that they may scale back their interest. The silver lining for Mexico is that it imports about half its petrol so lower prices are a bonus. Crude accounts for less than 15 per cent of Mexico’s exports and it has a hedging programme which it says will shield it from the impact of price falls in 2015. A $20-a-barrel fall in the price of Mexico’s oil next year would add up to less than 1 per cent of GDP, “not insignificant but still manageable from a fiscal perspective”, according to Moody’s, the rating agency.

Eurozone
The EU imports 88 per cent of its oil but its celebrations over plunging prices have been muted. At first glance, lower energy prices come as a welcome relief to European industry when it is struggling to retain competitiveness in relation to the US. In terms of consumer prices, Mario Draghi, president of the European Central Bank, called cheaper oil “unambiguously positive”. But he is also quick to identify the risks when the EU already fears that inflation is alarmingly low and could be veering towards deflation. Many countries have looked to inflation to alleviate the debt burden that is restraining their spending power.

The Losers

Russia
Russia is one of the world’s largest oil producers, and oil and gas make up two-thirds of Russia’s exports. For the Russian economy, the drop in the oil price as well as the Ukraine crisis has whipped up a perfect storm. As oil and gas account for 75 per cent of the country’s exports and more than half of its budget revenues, its currency moves in lockstep with the oil markets. The rouble, which had already been devaluing under the pressure of geopolitical risks, has plummeted since the fall in oil gathered pace. As a result, the $600bn burden that Russian banks and companies owe foreign creditors is getting heavier by the day — a worry that is even more serious because Western sanctions bar most of these borrowers from refinancing this debt with US or European banks. With Russia reliant on imports for almost everything except commodities, inflation has soared to 9.4 per cent and is expected to hit 10 per cent by the year-end.

Turkey
The oil price drop helps narrow Ankara’s current account deficit, a notorious economic weak spot. Turkey relies heavily on foreign fuel — last year’s energy import bill was $56bn — but officials say the deficit narrows by more than $400m for each $10 fall in oil. The impact on consumers is less favourable, since Turkey has some of the highest petrol taxes in the world. The IMF has warned that the economy remains “sensitive to changes in external financing conditions” and that a fundamental fix would require higher savings and ambitious structural reforms.

Iran
Tehran was already struggling with the impact of Western sanctions imposed over its nuclear programme before oil began to fall. The government of Hassan Rouhani is seeking to rebalance the economy to reduce its dependence on oil in next year’s $93.6bn budget from around 50 per cent to closer to one-third — which would be the lowest in decades. With no prospect of oil prices going up in the near future there is added pressure to strike a nuclear deal before the June deadline. US banking sanctions have cost Iran half its oil revenues. But an agreement could potentially allow Iran, which holds the world’s fourth largest reserves, to sell more crude and have access to about $100bn of foreign exchange reserves which it has been barred from accessing. Failure could lead to a shrinking of the economy and social unrest.

Saudi Arabia
Fiscal buffers are in place to offset the impact of any potential domestic deficit but Saudi Arabia — the world’s largest exporter — will still be among the Gulf nations most affected by lower oil prices. At $60 a barrel the kingdom, whose oil receipts accounted for 85 per cent of exports and 90 per cent of fiscal revenue in 2013, would experience a fiscal deficit equivalent to 14 per cent of GDP in 2015, according to Moody’s. Its vast foreign exchange reserves, estimated at close to $740bn, will offset some of the negative effects of much lower oil prices, but such a stressed scenario is still likely to mean a pullback in spending on social programmes which had increased substantially following unrest related to the Arab uprising. Even so, Riyadh has used its leading position in OPEC to resist calls for a production cut.

Venezuela
Venezuela is one of the world’s largest oil exporters. It was already finding it difficult to pay its way even before the oil price started falling. Inflation is running at about 60% and the economy is teetering on the brink of recession. The need for spending cuts is clear, but the government faces difficult choices. The country already has some of the world’s cheapest petrol prices – fuel subsidies cost Caracas about $12.5bn a year — but President Maduro has ruled out subsidy cuts and higher petrol prices.

Impact on Pakistan
The oil bills constitute the biggest item in the import list of Pakistan, thereby disturbing the balance of payments. Also, rising oil prices over the past few years have emptied Pakistan’s foreign reserves and are also impacting the price of the rupee, which has been declining against the dollar. Now, a fall in the oil price will reduce the import bills of Pakistan, thereby improving the balance of payments, foreign reserves and, of course, the value of the rupee. Also, this price fall will reduce the cost of inputs, which will be reflected in the prices of final products. Any reduction in the cost of production means a reduction of inflation in the country. The fall in oil prices provides Pakistan’s economy with some measure of breathing space. For both consumers and the government, lower oil prices will have far-reaching effects, on the condition that the recent oil price drop sustains and is not a temporary phenomenon.

Conclusion
The crude oil producers have seen good times for more than six years. It looks like the pendulum is swinging back towards a time of lower crude oil prices and consumers can again acquire energy at more reasonable rates. While this is bad news for the producers, it will have a dramatic impact on the world economy which has slowed considerably in recent years.