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|Time to Celebrate Cheaper Oil|
La Stampa - December 1st, 2014
It is the first really good news the European economy has had since 2008, and it has come from an improbable pair of benefactors--American shale-oil producers and Saudi Arabia—neither of them usually beloved to Europeans. But they deserve a heartfelt round of applause. For the drop in the global oil price of nearly 40% over the past six months they have caused is far likelier to revive Europe’s growth than is Jean-Claude Juncker’s fake public investment plan or any hope that Germany might one day change its mind over austerity.
Some commentators find the falling oil price worrying. They think that by reducing price inflation this will make life harder for the European Central Bank, which has dedicated its monetary policy to avoiding falling prices. Yet this worry is misplaced. Cheaper oil means greater purchasing power for consumers and industrial companies, enabling them to spend more money on other goods and services—ones that, unlike oil, are actually produced in Europe.
In this, falling oil prices are like a tax cut: they make you feel better off. And nobody objects to a cut in taxes, or worries that the ECB will have to counter the tax cut by trying to make other prices rise. They just enjoy it. That is the right attitude now to cheaper oil. It is not like the deflation suffered by Japan for more than a decade, in which falling prices led people and companies to postpone purchases, further weakening the economy. Cheaper oil will encourage consumers to spend more, and will boost business confidence.
The direct economic impact from the 40% fall in oil prices will vary from economy to economy. But a reasonable estimate is that, assuming it is sustained, it will add between 1% and 2% per year to GDP in Italy and in other West European countries. That may not sound like a lot, but when you are in recession, as Italy is, such a boost is like manna from heaven.
The question, of course, is whether it will indeed be sustained. Oil prices are notoriously volatile, unpredictable and above all political. They have been high for most of the past 10 years, apart from a brief slump after the 2008 Lehman shock, because demand for oil in China and other emerging economies was booming and the supply of oil had been restricted, thanks to tight control of production by the Arab leaders of the Organisation of Petroleum Exporting Countries (OPEC) and by low levels of investment in oil production outside the OPEC cartel.
Both of those factors have changed, over the past 2-3 years. The growth in demand for oil in China has slowed as that extraordinary economy has also slowed in its annual GDP growth rate from 10-12% to 6-7%. Most important, though, investment in oil production in the USA has boomed, thanks to technological improvements in so-called “fracking”, by which oil and natural gas can be recovered from reserves that previously were thought to be uneconomic. Thanks to that, the US now stands shoulder to shoulder with Saudi Arabia as the world’s two biggest oil producers.
US oil and gas production has been rising now for several years, but its impact on world oil prices was delayed, chiefly by political instability in North Africa and the Middle East. Revolution in Libya and civil wars in Syria and Iraq all hit oil supplies. But now, despite continued instability in Libya and the war against Islamic State in Iraq, oil is flowing quite steadily from both countries. So, with Chinese demand easing and Europe in recession, the balance between demand and supply finally led to falling prices.
At first, everyone expected Saudi Arabia to respond to those falling prices, from $110 a barrel in June to $80 by the beginning of November, by cutting its output. This is what it has done in the past, sometimes inducing other OPEC members to cut production too, sometimes on its own. But this time it didn’t. And then at OPEC’s regular summit meeting on November 27th it confirmed that it had no intention of cutting output. That sent the oil price slumping by a further $10 to around $70 a barrel.
The Saudis’ motives are, as usual, not entirely clear. Most probably, however, there are two main reasons and one subsidiary one. Their first main reason for allowing prices to fall is that they realise that this is the only way in which the climb in US oil production can be stopped. The breakeven price for US shale oil producers varies hugely, between $40 a barrel and over $100, but it is clear that these lower prices will hurt some high-cost producers and discourage further investment. That will at least cap US output until the technology improves sufficiently to lower the cost of drilling even further.
Their second main reason is to remind their fellow OPEC members who is in charge. Other OPEC countries, led especially by Venezuela, have routinely exceeded their agreed production targets, essentially stealing market share from the others. Such over-producers, who also typically need prices of $100-150 to balance their government budgets, needed to be taught a lesson.
The subsidiary reason is to hurt Vladimir Putin. The Saudis have fallen out of love with America, but resent Russia even more, especially for its support for Bashar Al-Assad’s regime in Syria and for the Saudis’ arch-enemy, Iran. The fall in the oil price has already caused the Russian currency, the Rouble, to collapse. Every month it stays low will hurt Russia, and especially its government finances, more and more.
Will it stay low? With oil, you can never be sure. Winter is coming in the northern hemisphere and, if it is especially cold, this might boost demand for oil. On the other hand, the Saudis look unlikely to change their attitude to output cuts at least until next spring, by when they will have seen how demand has developed during the northern winter and how resilient the US shale-oil producers have proved to be.
So for the time being, celebrate. Raise a glass to cheaper oil. It is the best economic news you are likely to get.