The record low for oil prices need not derail the green agenda

If cheap oil brings such benefits, why have the markets been so hard hit by the news? There is a straightforward answer

Hamish McRae
Tuesday 08 December 2015 19:10
comments
The drop in price of crude oil reflects a loss of confidence in the market after the latest meeting of Opec, where ministers from oil-producing states failed to cut back supply
The drop in price of crude oil reflects a loss of confidence in the market after the latest meeting of Opec, where ministers from oil-producing states failed to cut back supply

Just when you thought it could go no lower, the price of oil has plunged to the lowest level since 2009, with Brent below $40 a barrel – something that will have profound consequences for the entire world economy.

The immediate reason was the refusal by Saudi Arabia at the OPEC summit in Vienna last Friday to cut production, despite a global glut of oil. Most people, including some other members’ oil ministers, had expected at least a token cut in light of rising production in the US and the prospect of Iran returning to full output when economic sanctions are lifted next year. That has been the traditional role of Saudi Arabia, to be the swing member of OPEC, cutting production when demand and prices fall and pumping more when demand and prices rise. The market therefore expected a gradual recovery in the price.

But this time is different. Instead of cutting production, Saudi Arabia has continued to pump at a record rate, peaking at more than 10.5 million barrels per day (bpd) in June. For comparison, in the summer of 2014 before the price collapsed it was producing 9.5bpd, and its average since the first oil shock in 1973 has been 8bpd. Indeed it is producing so much oil that there are concerns that it may be at its technical limits: that it simply cannot produce more without damage to its oil fields. The reasons for this policy are not clear. It will have something to do with the politics of OPEC. In effect OPEC is no longer acting as an effective cartel. But part of the rationale seems also to be a desire to teach non-OPEC high-cost competitors, such as companies “fracking” in the US, a lesson in basic economics. In the oil world, the low-cost producers can kick the high-cost ones around.

The result, insofar as you can be sure about anything, is that the world is likely to have cheap oil for some years, but not forever. There is a precedent. In the late 1990s OPEC lost control of the market and the oil price briefly went below $10 a barrel. But as the long boom continued, with Chinese demand in particular climbing inexorably, the price was driven up to about $150 a barrel – as we all knew to our costs when we filled our car tanks.

If that is right, cheap oil will help drive economic growth for some years to come. The reason is that oil is vital to the world economy, not just because oil and gas together supply half the world’s primary energy, but also because oil is such an important chemical feedstock. It affects fertiliser prices, which in turn affect food prices. It affects transport costs, and it affects tourism which, with transport, is the world’s largest industry. This is not to say that cheap oil guarantees another long boom. Nothing guarantees anything. What it does mean is that the growth phase of the economy will not be constrained by a surge in industrial and commercial costs.

If cheap oil – and cheap energy – brings such benefits, why have the markets been so hard hit by the news?

There is a straightforward answer to that. It is that the costs of any sudden shock are immediate and obvious while the benefits take longer to come through and are more widely spread. So we notice the countries and companies that take a hit, countries such as Canada and Russia, as well as those in the Middle East, and – among the corporate sector – all the raw material producers as well as the oil majors. Because the FTSE 100 index is heavily weighted by oil and raw material companies, it has been particularly affected. But we don’t notice the benefits that accrue to all consumers from lower prices, lower heating bills, cheaper holidays and so on. It is a version of the 80/20 rule: 80 per cent of the economy benefits, and 20 per cent suffers, but we notice the 20 per cent more than the 80 per cent because the losers are more directly affected than the winners.

If you are unconvinced by this, think of the reverse situation. The oil price is around $50 and then over the next 18 months shoots up to $140. What happens then? Well, that was what did happen between the beginning of 2007 and the middle of 2008. We all know what happened then. The surge in oil was associated with the final mad months of the last boom. While it was not of itself the cause of the crash, it was certainly part of the boom that preceded it. Out of the five post-war recessions, the three most serious ones, those of the middle 1970s, early 1980s, and 2008/9 have all followed a surge in the oil price.

Are there longer-term and less obvious downsides to cheap oil? There is one legitimate concern that is worth highlighting in the context of the Paris climate talks. It is that cheap oil might take the pressure off the shift to a carbon-free economy. There is no doubt that if something is cheap people are likely to waste it. America began its, albeit uneven, retreat from gas-guzzlers in the 1970s after the first oil shock. If oil and gas had remained at the price levels of 18 months ago, alternative sources of energy such as solar power would have been close to being cost-effective without subsidy. The cost of renewables continues to fall but at present prices the crossover point is further away.

So in that sense, cheap oil does take the pressure off. But the shift to a lower-carbon economy is so established that it is hard to see a few years of cheap oil reversing it. Besides, once an airline has made an investment in a more fuel-efficient aircraft it is going to use it, even if the cost-advantage over its older, less-efficient ones is not as great as anticipated. Finally, in the short term, cheap oil and in particular cheap gas, helps reduce carbon emissions. The great polluter is coal. As it becomes cost-effective to shift the balance in electricity generation from relatively dirty coal to relatively clean gas, there is an immediate benefit to the environment.

Maybe the best way to see the plunge in the oil price is that it buys us time, time both to establish economic growth and time to develop renewables. So we should welcome it.

Join our new commenting forum

Join thought-provoking conversations, follow other Independent readers and see their replies

View comments