In recent months the price of crude oil has fallen 50%. This fall in the price of oil has a significant impact in reducing transport and other business costs. Falling oil prices is good news for oil importers, such as Western Europe, China, India and Japan; however, it is bad news for oil exporters, such as Venezuela, Kuwait, Iraq and Nigeria.
Impact of lower oil prices on oil consumers
Lower oil prices help to reduce the cost of living. Oil-related transport costs will directly fall, leading to lower cost of living and a lower inflation rate. Falling oil prices is one reason behind the fall in UK inflation to 0%
With stagnant real wages, this fall in the cost of living is important for giving Western consumers more discretionary income (more income to spend). 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.
Macro economic 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 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 limited impact on UK current account.
For oil exporters, a falling oil price is bad news. 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 are relying 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. This is why Saudi Arabia has so far not responded by cutting output.
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.
Firstly, the fall in oil prices is largely a reflection of weak global demand. Continued low growth around the world, is holding back demand. Thus the falling price of oil is a reflection of weak global growth – rather than the harbinger of economic recovery.
Deflation nightmare. The biggest fear in Europe at the moment is the slide towards deflation and the fear of a ‘Japan-style’ lost decade. EU inflation has fallen to a five-year low (0.4% in August 2014) 31% of Eurozone goods are now falling in price. This is a concern because deflation tends to cause serious macroeconomic problems:
- Lower consumer spending and investment – as consumers and firms delay spending and investment.
- Increased real debt burden – particularly a problem for indebted Eurozone economies who will find it harder to reduce debt to GDP ratios.
Falling oil prices give some relief to consumers with higher discretionary income, but given deflation and low consumer confidence, they are unlikely to spend it but prefer to save. Falling oil prices rather than helping increase spending are pushing down the headline inflation rate and making actual deflation a real possibility.
The fear is that once the Eurozone enters deflation, it could prove very difficult to escape (if it is not too late already) and it could lead to a long period of stagnant growth – which would be very bad news for attempts to reduce debt to GDP ratios.
Other economic impacts of lower oil prices
Reduced profitability for alternative energy sources. Part of the fall in oil prices is due to OPEC countries like Saudi Arabia wanting to protect their oil markets and not lose market share to ‘fracking’ and other energy sources.
Falling oil prices could delay investment into alternative ‘greener’ forms of energy, such as electric cars.
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 strong latent demand in Asia (India and China). Though there are fears of a slowdown in Asian growth, the fall in oil prices may be overdone. We can see that from the past six years – oil prices have been quite volatile – there is a strong likelihood that sometime oil prices will increase again.
Lower oil prices will be welcomed by UK consumers who will see a rise in discretionary income – after years of a real wage squeeze, this will help strengthen the economy. Falling oil prices will also help reduce headline CPI and allow the Bank of England to delay any rise in interest rates. But the problem is that – looking at the wider economic situation it is hard to get too optimistic. The overwhelming impression is of a very weak European economy, which is struggling with a dangerous mix of austerity, deflation, weak growth and debt. Falling oil prices will do very little, if anything, to tackle this fundamental problem.
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. See: article on Russian economic crisis.
- Are falling oil prices good or bad for the economy?
- Impact of rising oil prices
- Factors affecting oil prices in the short and long run
- Dealing with high oil prices