Commentary | 22 January 2015

Low oil prices provide a fleeting chance for reform

Low oil prices provide a fleeting chance for reform

Stephen Grenville

Nikkei Asian Review

22 January 2015

Please click here for the online text.

  • Stephen Grenville

Low oil prices provide a fleeting chance for reform

Stephen Grenville

Nikkei Asian Review

22 January 2015

Please click here for the online text.

  • Stephen Grenville

Executive Summary

Part of the problem is that economists, like many other commentators, find a gloomy story more interesting than a happy one. Also, every silver lining is part of a dark cloud, and economists will always find an "on the other hand" counterargument. With the oil price fall, there are winners and losers. And in any case, a sharp change in prices requires adjustments and adaptations, which often cause problems. This unexpectedly dramatic change is also a reminder that the future is uncertain, which encourages forecasters to hedge their bets and investors to be cautious.

Reasons to relax

So is this a big deal or not? Let us try to sort out the pluses and minuses. On the minus side, it might just be temporary. The oil price is clearly very sensitive to imbalances between demand and supply. In this case, a fairly modest increase in supply has produced a big price reduction.

Looking through the temporary fluctuations in the supply-demand balance, the key long-term factor is the marginal cost of producing oil -- how much does it cost the most expensive supplier to produce the last barrel of oil that is put on the market? The International Monetary Fund has given an insight into this by arranging estimates of production costs sequentially, essentially plotting out a supply curve (http://blog-imfdirect.imf.org/2014/12/22/seven-questions-about-the-recent-oil-price-slump/). Provided oil demand stays at about 93 million to 95 million barrels a day, the level predicted by the International Energy Agency, the cost of the marginal barrel is not far above current prices -- and certainly well below the $110 that prevailed until last June.

Could the price bounce up again? Saudi Arabia, one of the world's biggest oil producers, could decide to limit supply, as it did in the 1980s, but that seems unlikely. The strategy did not boost oil prices, and the Saudis gave up trying in 1986, after which the price halved to $14 a barrel. Limiting production now would transfer revenue to rival suppliers, some of which would use the income to oppose what the Saudis see as their vital interests in the Middle East. There clearly has been a supply increase, much of it in the U.S., with technology unlocking so-called tight oil, whose production is more than usually difficult, over the past few years. This additional production belatedly triggered the price fall when Saudi Arabia announced that it would not offset the extra supply by cutting production.

There has been a suggestion that the lower price reflects the eurozone's feeble economy -- an adverse demand shock to global growth rather than a beneficial supply-side shock. When, or if, the eurozone finally breaks out of its lethargy, the oil price might revert. But if the IEA has its forecasts anywhere near right, demand will not move into the high-cost part of the supply curve anytime soon, and in the meantime, alternative energy sources such as gas are gaining ground.

Winners versus losers

So far, so good. All these concerns about price reversion seem overblown. At least for the near future, the supply-demand balance suggests that somewhere around the current price, or maybe just a bit higher, is a sustainable equilibrium, although the sharp rise in the tail of the cost curve, which reflects the rapid rise in the cost of producing enough oil to satisfy substantial increases in demand, ought to be a reminder of the potential volatility of oil prices over the longer term. However, even if the lower price seems sustainable, it is not manna from heaven: This is a redistribution of resources, with winners (oil consumers) and losers (oil producers). While the winners will expand their economic demand and boost growth, the losers might contract theirs. Does the bad news for net oil exporters exceed the benefit to net importers?

The big Middle Eastern exporters are so rich that they do not spend all they earn, so redistributing income away from them has to add to global demand. Some net exporters -- Russia, Iran and Venezuela -- are regarded with suspicion by many first-world countries, which will not care about their loss of income. It might even cause them to change aspects of their behavior that the West finds objectionable. But if the impact were so bad that one of them had a total economic collapse -- say, Russia, where oil exports are equal to 13.5% of gross domestic product and provide half of the government's budget revenue -- the spillover would damage the whole world. The political implications might be huge. The fall in oil prices in the 1980s did not cause the collapse of the Soviet Union, but it certainly made the "Evil Empire" more susceptible to the forces undermining it.

The net impact on consumption is clearly positive for global growth, but the downward price shift will discourage investment in energy production, which will trim overall economic demand. The boom in petroleum-related investment in North America has already faded, and if gas prices mimic the fall in oil, incentives for investment will be weakened across the whole energy sector. North America illustrates neatly the two-edged effects of lower prices: Consumers are driving more and turning up the heat, but some of this boost to demand is offset by weaker investment.

The lower oil price is unambiguously bad news for those worried about the environment and climate change, as cheaper oil will encourage all of us to use more energy and will reduce incentives for energy-saving innovation. At the same time, however, the price fall offers a golden opportunity to offset the climate-damaging externalities of oil -- the environmental costs of its use that are not reflected in its price -- by imposing a carbon tax. This would make carbon-based energy more expensive, encouraging lower consumption, while at the same time raising revenue that could be used to give energy consumers the benefit of the oil price fall. The combination of expensive gasoline (thanks to a tax) and a general income subsidy (or a reduction in other taxes) would be good news for the planet.

Mixed blessings

Not every country receives the same benefit from lower oil prices. Some, like Indonesia, are producers as well as consumers, and for these countries the net economic impact will depend on the balance of production and consumption. Indonesia will be a net beneficiary because it has been a net oil importer for the past decade. For countries with larger net energy imports, such as Japan, China, India and Thailand, the benefits will be more substantial. For Japan, the weaker yen may mask the size of the fall in oil prices, but the full benefit will nevertheless be received by Japanese consumers in the form of gasoline prices that are lower than they would otherwise have been. If we were searching for a downside in Japan, we might note that it will be a bit harder to get inflation up to the Bank of Japan's 2% objective.

For net oil importers, the benefits are not confined to lower prices at the pump. There will also be a positive effect on the current account of the balance of payments as oil import costs fall. Falling energy prices will help businesses in the manufacturing and services industries by helping to keep input costs down. In emerging economies where petroleum consumption is subsidized, including Indonesia, Malaysia, Thailand and many others, the lower world price will reduce pressure on government budgets.

The politics of petroleum pricing has a long and fraught history, nowhere better illustrated than in Indonesia. During the 1997-1998 Asian financial crisis, it was the IMF-enforced requirement to raise gasoline prices that triggered riots that led to the demise of the Suharto regime in May 1998. Since then, there have been continuing tensions due to political resistance to price increases and the pressing need to rein in the subsidy, which has accounted for around one-fifth of budget expenditure. In November, shortly after his election, President Joko Widodo took the brave step of raising the gasoline price by 2,000 rupiah ($15 cents) per liter, only to find that no subsidy was needed by year's end, and in fact the price could be lowered by 900 rupiah even without the subsidy. From now, gasoline prices will be set each month based on the key global supply price. This does not entirely remove the budget burden, however, as diesel still has a small subsidy, kerosene still sells for a subsidized 20 cents per liter, and electricity is still heavily subsidized.

Malaysia illustrates the quandary for an oil producer, where price hikes are met by the argument that "the oil belongs to us, the people, so it should be cheap." While the subsidy has, in a formal sense, now ended, Malaysia still has the low price typical of a producer -- so low that measures have to be taken to limit the opportunity for Singaporeans to cross the causeway into Malaysia to benefit from the more-than-double price differential.

In Thailand during the last decade, a budget-supported fund has kept petroleum prices, particularly diesel and liquefied natural gas, below politically sensitive levels. Lower world prices have now enabled the government to more or less end these subsidies, with relative prices adjusting accordingly. Alternative fuels are substitutable, such as diesel rather than gasoline, or even cooking gas rather than gasoline. Letting the market set price relativities is a move in the right direction.

Fleeting chances

Finance ministers and the public alike are generally glad to see the end of subsidies. But given that world prices could rise sharply -- not likely in the short run, but possible in the longer run -- gasoline prices remain politically sensitive. Subsidies, previously swept aside with relief, would be back on the agenda.

On balance, the current situation is definitely good for global growth, but by how much? In the IMF's most recent World Economic Outlook, issued in October, the fund still saw the main risk as an oil price increase, with a $25 per barrel rise estimated to cut at least 0.5% off global growth. Now that we are looking at a price change twice as large and in the opposite direction, the fund's tentative estimate is that it will add between 0.3% and 0.7% to world growth this year. When the fund incorporates this into its updated global forecast later in January, we will see whether it breaks the unrelieved gloom that has permeated discussion of global economic prospects since 2008.

For policymakers in net oil-importing countries, the loosening of budget and external constraints provides an opportunity to turn a short-term fillip to growth into a sustainable breakout from the lethargic pace typical of the post-2008 period. Governments could reinforce the oil price boost with structural reforms, directing the oil windfall into the priority areas relevant for each country, whether that is budget reform, industry restructuring or infrastructure. Farsighted policymakers would address climate change. Opportunities like this come rarely. But the cautious commentary we have seen so far suggests that this chance will slip by, almost unnoticed.

 

Stephen Grenville, a former deputy governor and board member of the Reserve Bank of Australia, is a visiting fellow at the Lowy Institute for International Policy in Sydney and a consultant on financial issues in East Asia.