Cheaper oil shouldn’t be feared – we’ll all have more to spend

If it costs less to fill up the car then there is more to spend in the supermarket. We buy more overall, not less

A derek pumps in a oil field (Getty)

The oil price may stay low for a long time. Is that good or bad for the world economy? Just about everyone failed to spot the collapse of the oil price, including a former oil economist called Alex Salmond, who lost a wager made just before the Scottish referendum that the price would never fall below $50 a barrel. He paid up on the nail: a crisp $50 bill landed on the desk of the winner of that interchange within a week of the price dipping below the magic level.

But that was last year. Brent was around $31.50 yesterday afternoon. Until even a few weeks ago, a price below $50 seemed unlikely to be sustained in the long term. An awful lot of US shale producers certainly hoped so and, given the record of Opec in the past of cutting production to shore up the price, that seemed a reasonable assumption. Now the drip-feed of news has led to a growing concern, for some a fear, that not only might the price fall further still, perhaps to $20 a barrel, but that we might have several years of prices at around the present level.

For example, just yesterday the chairman of Saudi Aramco, Khalid Al-Falih, said that the company would maintain its investment programme and could sustain low oil prices for “a long, long time”. Saudi Arabia is the world’s largest oil exporter. China is the world’s largest oil importer, and yesterday it revealed that diesel consumption there had dropped for the fourth month on the trot. The oil price, which had recovered a bit in the previous few days, was clobbered by these two stories and duly fell back again.

There are further reasons to suspect that the supply/demand relationship will remain very weak in the months ahead, including the re-entry of Iranian oil supplies on to the world market. Last week, Iran announced that it would increase production by 500,000 barrels a day, while Bob Dudley, the BP chief executive, said it was “not impossible” that the oil price could fall to $10 a barrel, though he believed it would recover to “$30 to $40 by the middle of the year” and eventually rise to the $50 region by the end of 2016. That is more bullish than the level the forward markets predict, but let’s assume he is right and that what seemed an unthinkably low price 18 months ago is the new norm. What then does this mean for the world economy?

There are two views. The conventional one, or at least the one that seems to be driving share prices at the moment, is that this spells trouble. Not only will the oil companies have to cut more staff (as they are already doing) and pare back investment – both of which will have a dampening effect – dividends are under threat, too. Worse, there are dangers of disruptive effects that by their very nature cannot be predicted. There will be bankruptcies and defaults. The sovereign wealth funds, most of which have relied on oil royalties to puff themselves up, may become forced sellers of securities. This will lead to further falls in price levels, and the central banks will be unable to do anything about it. All of this will have knock-on effects that will at best damage growth and at worst become a trigger for the next global downturn.

This would be a glum prospect indeed. Mercifully, there is an alternative view, which to many of us seems less shrill and more sensible. It runs like this.

There are clear and obvious losers from the collapse of oil prices. These include the producing countries, especially Russia and the Middle East, and suppliers to the industry more generally. There will be disruption as a result. But the “losers” will be more than offset by the “winners”. These include all importing countries, especially in the developed world in Europe and Japan, and in the emerging world, especially China and India. In macro-economic terms this is a boost to real demand that comes at just the right time.

So why are the markets not celebrating this? I have been looking at some work by Paul Donovan, a global economist at UBS, which points to some of the explanation. One central point is that lower oil prices will reduce inflation as measured by the consumer price indices, but this is not the same as “deflation”. Inflation and deflation are general price changes. What is happening here is a specific price change, albeit one that pulls down other prices because it is such an important input.

So it will encourage consumers to expect falls in prices of other items and to some extent this may happen. But this is different from general falling prices driven by lack of demand. Unless consumers are spooked by the adverse news stories, buy less stuff and, accordingly, do push down demand more generally, cheaper oil should not be feared. Indeed, the common sense response that if it costs less to fill up the car then there is more to spend in the supermarket is surely a more sensible one. We end up buying more stuff overall, not less. Therefore GDP rises, not falls.

By how much? Some calculations by Oxford Economics suggest that a $20 decline in the price of oil increases the GDP of most countries by between 0.25 per cent and 0.5 per cent. The US and India are towards the top end of the scale, and the UK, Japan and Germany are towards the bottom, with China in the middle. Russia loses about 2.6 per cent of GDP, and Saudi Arabia about 2.4 per cent, but there are not any really big economies that are net losers.

If this line of argument is right, how long will it take for financial markets to recover their mojo? Whatever happens in the next few weeks, a more general recovery in confidence will, I suggest, be quite a while away. Equities in particular have had a long bull run and some other asset prices (London property?) have been pushed to extended levels. There was always going to be a rethink and that is happening now. But if the oil price does remain low for, say, another three years, that will help preserve this growth phase of the economy. Growth will not be choked off by expensive energy.