Don't fear the oil price crash - unless it heralds the beginning of a global downturn

Cheaper oil should provide a massive stimulus to the global economy, unless the commodity is getting cheaper for the wrong reasons

A huge rise in oil supply has pushed down energy costs Credit: Photo: © Stephane Compoint / eyevine

No one watching the past week’s oil price moves could be more smug than a Scottish unionist. As the price of Brent has plunged, many will be glad that Scotland did not decide to go it alone.

Economic predictions by the Scottish government formed the backbone of the case for independence. They rested on the assumption that a barrel of crude would fetch $110, which it had in the summer of 2014. The commodity’s price has since crumbled, falling below $30 over the past week.

Nicola Sturgeon, Scotland’s First Minister and SNP leader, has admitted the party got it wrong. If Scotland was now an independent economy, it would be facing the same kind of fiscal threat as many oil-exporting nations.

Scotland's First Minister Nicola Sturgeon during her debut First Minster's Questions in the Scottish Parliament
Nicola Sturgeon, the SNP leader, has admitted her North Sea oil predictions were wrong

Already, the Scottish economy has begun to reel. GDP grew just 0.1pc in the third quarter of last year, against growth of 0.4pc across the UK as a whole, according to the latest figures.

However, Sturgeon noted that, while the Scottish government’s predictions came undone, so too did those of practically other forecaster.

When the SNP was talking about $110 a barrel, the UK Government’s Department of Energy and Climate Change had pencilled in a price above $120. “Everybody’s projections about oil were wrong,” Sturgeon concluded.

Forecasting oil’s movements is notoriously difficult, but it is a variable that cannot be ignored. Its recent moves have already reverberated through financial markets, driving stock and bond prices. Changes in the price of oil will force governments to reassess their spending plans, and central banks to re-examine their plans for interest rates.

There has been a competitive cacophony from the largest investment banks since the start of 2016, as barely a day has gone by without cuts to oil price forecasts by some research house or another. These bearish views on the oil market “appear as close to unanimity as any we can recall”, says Neil Mellor, a BNY Mellon strategist.

By the end of last week, Standard Chartered had the most extreme prediction. The emerging market-focused bank believes crude could trade at $10. Prices could fall further as investors assume US shale production will be resilient in the face of price movements, analysts said. “In the extreme case, the only definition of a floor would come when the entire market felt that prices had undershot too far.”

Like other commodities, supply and demand drive what price crude will fetch on global markets. The emergence of the US as an oil producing powerhouse has been pivotal in prompting the slide.

Staff at the European Central Bank (ECB) have calculated that rising supply has been the dominant force in pushing down prices. As the US has switched on fracking technology to get oil out of the ground, global production has exploded.

The grip of the Organisation of Petroleum Exporting Countries (Opec), the oil cartel, has loosened accordingly. At its most recent meeting, members failed to agree on a new production ceiling.

The International Energy Agency (IEA) estimates that global oil production stood at 96.9m barrels a day in the third quarter of last year. In that period, it believes there was demand for just 95.4m barrels a day.

Iraq has made plans to export a record 3.63m barrels per day next month, and while US supply growth may be slowing, it remains near 45-year highs. Iranian production is soon expected to add to the mayhem, flooding an extra 730,000 barrels a day on to already oversupplied markets.

Interactive: Oil stats

Economists say lower oil prices are, for the global economy, a positive thing. Cheap energy acts as an effective tax cut, they say, reducing fuel costs and utility bills. In turn, the budgets of households and firms are looser, buoying spending and investment.

However, if the oil rout is a mere precursor to a downturn in the global economy, all bets could be off. The demand side of the equation has done little to prop up prices. Fears over the Chinese economy have fed into wider concerns about the health of emerging markets and the global economy. Lower growth inevitably means less demand for oil as an input for production.

It is this latter factor that has greater potential to unnerve. If the driver of oil price falls has been the strength of the global economy, then things may become much worse before they get better.

Mario Draghi, new President of the European Central Bank (ECB), speaks to the media following the first meeting of the ECB Governing Council with Draghi at the helm on November 3, 2011 in Frankfurt am Main, Germany
ECB President Mario Draghi has warned that even higher supply could have economically damaging effects

Weak oil prices could lead to falling net exports, causing businesses to cut investment, and forcing inflation lower. “This blunts the growth-bolstering effect of lower commodity prices,” said Mario Draghi, the ECB's President.

Even if demand is not to be blamed, a succession of supply shocks could have a similar effect. Enough of them can occur so that inflation is low for so long that it causes firms and households to revise down inflation expectations. “The effect of supply shocks becomes more similar to demand shocks,” Draghi added.

On the frontlines of the oil slump are the commodity’s producers. Those especially reliant on oil for revenues have suffered since the rout began in the summer of 2014. Things have become even worse for these exporters in recent months, as the second wave of the oil sell-off began.

The most prominent victims have included Russia, as well as many Gulf and Latin American states. A substantial number have failed to develop other parts of their economies, instead relying on oil for prosperity.

Their struggles can be characterised as a kind of “resources curse”, as governments made rich by rent extraction have lacked the drive to implement the right policies to shore up economies against a potential collapse in prices. These leaders must now reckon with their failure to prepare.

Perhaps it comes as no surprise that they have already hit out at the West. Vladimir Putin, Russia’s president, has suggested a conspiracy, that the crude slump has been engineered by political forces. “The obvious reason for the decline in global oil prices is the slowdown in the rate of [global] economic growth which means consumption is being reduced in a whole range of countries,” he said as the sell-off became apparent in 2014.

Mr Putin cannot allow himself to believe that the Kremlin's favoured strongmen in former Soviet Republics are actually unpopular
Vladimir Putin, Russia's President, has suggested that political forces have meddled with oil prices

“A political component is always present in oil prices. Furthermore, at some moments of crisis it starts to feel like it is the politics that prevails in the pricing of energy resources,” he added. It is estimated the total cost to oil exporting countries like Putin’s could exceed $2 trillion (£1.4  trillion).

Yet even for the oil importing nations, which make up the majority of global GDP, the fall in oil prices can be a mixed blessing. While for many manufacturers cheaper energy means lower costs and greater profitability, the sector as a whole has been beaten down along with oil prices.

In the US especially, the industrial side of the economy is at risk, as lower prices feed through into capital expenditure cuts. Energy’s share of capital expenditure has already fallen from 10pc to 5pc. The good news is that it is unlikely to fall further.

“One of the best pieces of investment advice I have heard is to buy when the news is the worst,” says Torsten Slok, Deutsche Bank’s chief international economist. Energy’s share of investment “can only fall five percentage points more before we get to zero, and getting to zero would be unprecedented”.

Rather than causing an economic crisis, the worst of the oil price slump may already be over. The depressant effects of falling commodity prices hit hard and fast. Their positive impact almost always takes longer to trickle through the economy. We may now be seeing that inflection point in the West.

“We are likely to see downward pressure on GDP from the energy sector over the coming quarter or two but we now have the worst behind us in terms of the negative impact of falling oil prices on the economy,” says Slok.

Dario Perkins, an economist at Lombard Street Research, says the spillovers from US shale to the wider economy have been “nowhere near as gruesome” as some commentators were warned. Rather, lower energy prices have provided a “significant boost to consumers”, he says, noting buoyant car sales in the US and Europe.

If cheaper oil does not hurt the overall economy, it will certainly cause no small amount of distress for those worst hit. But this is small scale. Central bankers will be more worried that the dynamics driving oil could change.

Unless oil prices bounce back, there will be more questions. Could the oil stimulant become a poison? Policymakers will be on the lookout for signs of weaker demand, or indications that individually innocuous increases in the supply might metastasise, permanently reducing people’s inflation expectations.

Almost as many analysts convinced that oil will fall further forecast that it will climb back by the end of the year, reflecting a firming of growth.

The oil market has already dictated the dynamics of the global economy for much of the past two years. Its price is likely to serve as a barometer for the world’s health for a while to come.