The era of low oil prices is here to stay.
The most recent surge in the fuel was heralded by fracking technology, which enabled the United States to become the largest producer and consumer of oil. An oversupply of oil brought prices tumbling down. Saudi Arabia, which holds the world's largest proven reserves of oil and was the swing producer until recently, brought prices further down by refusing to cut back on production levels. Non-OPEC members, such as Russia, have followed suit and are only adding to the oil glut. In response, oil prices have dropped by 58% in the last year, dipping below $40 for the first time since 2009.
At first glance, low oil prices should be a net positive for a country's economy because they translate to increased consumer spending and low manufacturing costs. But, low oil prices can have a mixed effect. For example, low oil prices can eat into profits for oil companies and affect inflation. (See also: What Is The Relationship Between Oil Prices And Inflation).
Given the current situation, then, who wins or loses with low oil prices?
A Reboot Of The 1980s?
History may provide some answers to that question. When the United States was the largest producer of oil in the world, the commodity followed simple rules of supply and demand. The 1973 oil embargo by Arab nations against the United States changed that briefly. But, a number of factors, such as the rise of renewable energy and emergence of non-OPEC oil producing countries, tilted the oil markets back in favor of market economics.
The last time that oil prices went into a free fall was in the 1980s. Then, Saudi Arabia, which was the swing producer, responded by increasing its production capacity to fight for market share. The result was a precipitous drop and prolonged price instability for a decade. A change in the pricing mechanism – which is now based on a complex system of forecasts, futures, and signaling – has ensured an equilibrium between OPEC economics and free market economics. (See also: What Determines Oil Prices?)
The current set of circumstances is not unlike the situation in the 1980s. The arrival of a new player – the U.S. shale oil industry – has upturned the supply dynamic. But a cocktail of depressed demand and changed geopolitical circumstances has made the business of predicting the future of oil demand difficult.
How Do Low Oil Prices Affect Economies?
According to the International Monetary Fund, low oil prices will have a net positive effect on the world economy. The fund revised its growth estimates to a figure between 0.3% and 0.7% based on the crash in oil prices last year. As an example, U.S. exports in manufacturing increased by 6% this year, thanks to low shale oil prices.
At the micro level, low oil prices adversely affect oil company earnings. According to Deloitte research, low prices affect valuation models for future profits. In turn, they increase costs for risk associated with impairment. Research firm Goldman Sachs estimated that $1 trillion of spending on future oil projects was at risk, when crude oil prices dipped to $70 per barrel. According to estimates by Barclays, a research consultancy, a $20 drop in oil prices results in a 20% drop in EBITDA earnings for U.S. oil companies.
At the macro level, they can bring down import costs and eliminate or reduce subsidies related to the fuel. According to the IEA, oil subsidies cost $550 billion to the world economy. A reduction in subsidies has the overall effect of bringing down budget deficits in countries. In the case of oil-importing economies, this is a net positive effect. For oil-exporting economies, however, the effect is mixed.
Low Prices And The Two Most Important Oil Economies
As an example of the latter case, consider the case of two of the largest producers and consumers of oil today: Saudi Arabia and United States.
Low oil prices will help the United States import more oil at reduced rates. But, that may not amount to much since the share of oil imports in the overall oil mix is declining. For example, oil imports reached their lowest level since 1985 at 27%. The prices also spur consumer spending, which is good for the U.S. economy. (See also: How Oil Prices Impact The US Economy.)
On the flipside, however, low oil prices may make shale oil unsustainable in the long run. This is because it is more expensive to extract shale oil as compared to crude oil. The economics of the shale oil industry have yet to reach the scale of the crude oil industry. As things stand now, there are a limited number of states and refineries that have benefited from the shale boom. Unless there is a significant breakthrough in reducing costs or Saudi Arabia backs down from its high production quota, the shale oil boom could sputter out quickly. According to a June note by Goldman Sachs, reduced investment in energy equipment due to low oil prices resulted in half a percentage point drop in economic growth this year.
Despite its bountiful reserves, Saudi Arabia also may not find the going easy. Low prices have translated into decreased profits and increased budget deficits. The situation is complicated by the fact that its social sector spending has increased since the Arab Spring uprising and the rise of ISIS.
The country also faces a serious problem with energy consumption. It is the largest consumer of energy in the Middle East and uses the maximum amount of oil in the world to produce electricity. It is also the second-biggest spender on fuel subsidies after Iran. Saudi Arabia's plentiful foreign reserves ($741 billion, at last count) may help the kingdom to ride out the current slump until oil prices find a floor again.
The Effect On Other Economies
Other oil producing countries may not be so lucky.
For example, Russia loses $2 billion in revenues for every dollar drop in the price of oil. Low oil prices have resulted in economic contraction during successive quarters and dipped ruble rates. (See also: How Long Can Russia Survive With Low Oil Prices?)
At the beginning of this year, IMF predicted GDP growth rates of -3.7% for Russia this year. With continued low oil prices and a global swoon, next year does not promise better tidings. Bank of America Merrill Lynch has revised its GDP outlook for the country from +1.1% to +0.3% in 2016.
Venezuela's economy is in shambles due to low oil prices. According to the Financial Times, the country's oil income has halved this year and drastically reduced its foreign exchange reserves. The results cut backs in social spending have fomented social unrest. A further drop in oil prices could tip the country into chaos. Nigeria's problems are not dissimilar and the country's economy has recently termed as “Africa's most important failure” by the Economist.
On the other hand, low oil prices are expected to benefit economies with industries that consume oil, such as manufacturing and agriculture. China and India are examples of such economies. In the former case, China's GDP would increase by approximately 0.15 percent for every 10 percent drop in the global price of oil, according to a Bank of America/Merrill Lynch analyst. But, a slowing economy could offset that increase.
For India, the effect is even more pronounced since a dollar of farm output takes four or five times as much energy to produce as a dollar of manufactured goods. The current oil glut has the potential to wean India off oil subsidies, temper its inflation and bolster its economic prospects according to IMF's World Economic Outlook.
Finally, the effect of low oil prices on Europe has been mixed. Low oil prices were supposed to be good news for retailers. But, deflation has spoiled the good news. With increased consumer spending, lower heating costs, and more discretionary power, however, the overall effect is expected to be positive.
The Bottom Line
The last time oil prices bottomed out in the 1980s, it took them more than a decade to find a reasonable floor. Given the changed geopolitical circumstances and rise of renewable energy, the situation this time around is much more complicated. The winners and losers of the current oil price slump may very well determine the new world order.