A fall in oil prices should cause a reduction in transport and fuel costs for firms. Consumers who will also benefit from the lower prices of transport and fuel. The lower oil prices will effectively increase their disposable income and enable them to spend more on other goods
Because oil is the most traded commodity and has a significant bearing on global transport costs, it should lead to inflation and can lead to higher rates of economic growth.
However, sometimes oil prices crash because there are fears of an economic recession. In this case, falling oil prices are not sufficient to increase economic growth because other factors keep growth low. Also, if oil prices fall sufficiently, it can cause some oil firms to go out of business and this causes a rise in bad debts.
Also, falling oil prices will have differing effects depending on the country. Oil importing countries (e.g. Germany, Japan, India) will generally benefit from oil lower prices, but developing economies who rely on oil exports (e.g. Russia, Venezuela) could see a significant fall in export revenue.
Oil price fall 2020
The oil price fall in March 2020 has pushed oil to its lowest prices for many years. The above graph shows nominal prices and not adjusted for inflation.
Usually, a fall in oil prices would be greeted by consumers and firms due to the lower prices and costs. However, this fall is due to expectations of a sharp drop in travel and economic recession from the coronavirus. Therefore, there is little expectation that the lower oil prices will have any positive economic effect. If people cut back on travel, cheaper petrol doesn’t make much difference. If people see a fall in income because they are out of work, cheaper oil prices are only a small compensation.
More detail on lower oil prices
Products made from petroleum
Oil is a commodity used not just in petrol and diesel but many other products, such as
- Motor oil, plastics, clothes, solar panels, floor wax, ink, bearing grease and other 40 everyday products (Products made from petroleum)
- Therefore, many goods will see a marginal fall in cost of production when oil prices fall.
Impact of lower oil prices on oil consumers
Lower oil prices help to reduce the cost of living. In particular, if a household owns a car or uses other forms of transport reliant on oil. To a lesser extent, all goods should become cheaper due to lower transport costs.
This fall in the cost of living is especially important if real wage growth is low which has been the case in recent years. A fall in oil prices is effectively like a free tax cut. In theory, the fall in oil prices could lead to higher spending on other goods and services and add to real GDP.
Problem of Bad debts
In 2020, oil prices have fallen so far that the price of oil is selling for a lower price than the cost price for producers in US and Russia. Saudi Arabia has pushed the price below $30. But, this damages many oil firms have who borrowed to invest in new oil fields. This could lead to firms closing down and going bust.
Macroeconomic impact of falling oil prices
- Lower inflation
- Higher output
This diagram shows that a fall in oil prices (and a fall in firms costs) will shift the short-run aggregate supply (SRAS) to the right, causing lower inflation and higher real GDP. (Some economists say on average a 10% fall in oil prices leads to a 0.1% increase in GDP (BBC article on falling oil prices)
3. Balance of payments
Oil importers will benefit from a falling oil price because the value of their oil imports will drop. This will reduce the current account deficit of oil importers; this is important for a country like India who imports 75% of oil consumption and currently has a large current account deficit. However, for oil exporters, a falling oil price will do the opposite reducing the value of their exports and causing lower trade surplus. The UK is currently a small net importer of oil, so will have a limited impact on UK current account.
For oil exporters, a fall in oil price is damaging to the economy. Many oil-exporting countries rely on tax revenue from oil production to fund government spending. For example, Russia gains 70% of all tax revenues from oil and gas. Falling oil prices will lead to a government budget deficit, and will require either higher taxes or government spending cuts. Other oil exporters like Venezuela have relied in the past on oil revenues to fund generous social spending. A fall in oil prices could lead to a significant budget deficit and social problems.
Other oil exporters, such as Saudi Arabia and UAE have built up substantial foreign currency reserves; they can afford temporary falls in oil prices because they have substantial reserves.
Why falling oil prices is not enough for Europe?
Usually falling oil prices would be welcomed by oil importing countries. However, many are deeply fearful about prospects for the European and global economy.
Other economic impacts of lower oil prices
Reduced profitability for alternative energy sources. In recent years, there has been an incentive to invest in renewable energy and electric cars. A prolonged fall in oil prices will reduce this incentive and encourage firms and consumers to stick with oil.
Falling oil prices could delay investment into alternative ‘greener’ forms of energy, such as electric cars, and this could have negative consequences
Long-term falling oil prices could reverse the recent decline in-car use, leading to a steady increase in traffic congestion and environmental costs of petrol use. (see: post on case for increasing tax on petrol)
A few years ago, oil prices were rising through the roof, and many expected high oil prices to be the new norm. It is unlikely OPEC will want to tolerate low oil prices for too long. There is still a strong latent demand in Asia (India and China). The coronavirus could prove to be a very severe economic shock, which leads to a deep recession in 2020. However, it will not last – experts predict by 3-6 months, the worst should be over. This could cause a strong economic recovery and prices quickly bounce back.
Example – effect of falling oil prices on Russian economy
The Russian economy is highly dependent on the oil and gas industry. The fall in oil prices caused a rapid devaluation in the Rouble and contributed to a recession.