Is Oil Low Price Going to Sustain the Economic Recovery?

During the last part of 2014, optimism steadily raised over the unusually low prices of oil and their allegedly positive economic effects on the economies of oil importing countries. Although some evidence points in this direction, a more thorough assessment leads unfortunately to different conclusions.

The Deceptive Optimism

Late in January, the International Monetary Found (IMF) had released an important update for its World Economic Outlook of October 2014 (WEO). Unsurprisingly, growth predictions were cut compared to previous versions of the report. There are some considerations of particular interest for what concerns the effects of the favorable oil price on the global economy.

Proceeding with order, we should first examine a couple of relevant facts and figures. The updated document starts by first supporting the idea that the current level of the oil will benefit growth, except immediately correcting this statement by remarking that “this boost is projected to be more than offset by negative factors, including investment weakness as adjustment to diminished expectations about medium-term growth continues in many advanced and emerging market economies.”

The second piece of information is that “oil prices in U.S. dollars have declined by about 55 percent since September”. For comparison the price on average has dropped by about $55 on average since mid-2014. So, following estimates by William C. Dudley, President and Chief Executive Officer of the Federal Reserve Bank, in his recent speech “The 2015 Economic Outlook and the Implications for Monetary Policy”, the implication is a potential wealth transfer in the order of $2,000 billion from producing countries to importing countries.

The main point to remember at this stage is that the mechanism through which the advantageous cost of fuel would impact the economy positively works by theoretically encourage the investments first, and subsequently the demand for goods. That in theory, but to all effects that is not happening, as by admission of the IMF itself, and we shall see why in a minute.

No Winners?

Indeed, the depressed price of oil could paradoxically sink investments even further, under the pressure of the markets' expectations, which despite these considerations remain negative. And when expectations are negative investments stagnate even if otherwise all other conditions are favorable.

Moreover, at the same time the producers will suffer from their diminished financial resources, which are slowly drifting toward the consumers, and in turn this could trigger a decrease in the demand of goods. Both these factors tend to trigger deflative effects, especially on the side of the suppliers, with a further negative outcome for the concerned economies.

In other words, the increased buying power of the consumers - even if it was actually used to any extent, something which is far from certain - would be counterbalanced, or even outbalanced, by the deteriorated spending power of the producers.

At the moment of this writing a barrel is still being sold for slightly under $60, definitely higher than the 5-year low hit in January 2015, when the U.S. Crude Oil reached an impressive $45.90. Nevertheless, if the price stabilized below this theoretical 60-dollar mark - a prediction many analysts seem to agree upon - the aforementioned shifting in wealth from producers to importers benefits only some of the latter under certain conditions - namely those were expectations are optimistic enough to kick-start an increment of the investments - while the former are getting the worse end of the deal, including the exposure to financial speculation.

Then, as partially anticipated, there's the financial risk. Many producers have incurred in heavy debts to finance their development, confiding in their revenues from oil sales to repay them and in the favorable interest rates, Venezuela being a prime example. Then even if not so financially exposed, some recessive effects are doomed to happen anyway. For example, according to the IMF, in 2015 Russia will supposedly lose a chunk of its GDP amounting to 3%.

That would explain why the reduced oil price is not sufficient to shake the economy at global level and induce growth again, barring some exceptions, most notably the U.S.A.

“The revisions reflect a reassessment of prospects in China, Russia, the euro area, and Japan as well as weaker activity in some major oil exporters because of the sharp drop in oil prices. The United States is the only major economy for which growth projections have been raised.” (Source WEO)

Somewhat remarkable in the U.S. case, the growth is following the crisis of shale industry, which was allegedly the revolutionary approach that would should have brought energy independence and strengthened the economy. Just to give an idea of the latest proportions of the crisis of the American oil industry let's just remember that in the last week of January 94 oil rigs were idled in the United States and 11 in Canada behind concerns springing from the oil price. Measures that severe had not been adopted since 2009.

A Wider Look at the Causes

The question remains about the reasons why some oil producers are not cutting back on their production. Some of them simply can't, because they are so pressed by the interests on their national debt that the net loss from selling less product would be unbearable in the short run, even if it may yield better returns in the long term. Some others would instead benefit, but deliberately chose not do so, most notably Saudi Arabia. Countries belonging to this group may be employing this strategy to gain a competitive advantage over a broader time horizon. If you are interested in an in-depth analysis I refer you to my previous article A Chess Match for the Control of Oil.