Oil price fall - shot in the arm or zero sum game ...

Christine Lagarde, speaking at the Council on Foreign Relations this week,  suggests the drop in oil prices is a welcome shot in the arm for the global economy? Cheaper oil increases real consumer purchasing power [by real income and product substitution effects]. Private demand is boosted in oil-importing countries. “If oil prices will remain at low levels, oil could provide a positive contribution to global growth for some time to come”, says the head of the IMF.

But is that really the case? In game theory a zero-sum game is a mathematical representation of a trade off in which a participant's gain (or loss) is exactly balanced by the losses (or gains) of the other participant(s).

So it is with oil. The oil price fall is a zero sum game in which there are winners and losers. The net overall gain (or loss) to the world economy is neutral at best.

The World Value of Oil …
We estimate the world value of oil was worth some $3.6 trillion in 2013, based on an average price of $110 per barrel. Falling to $50 per barrel, the loss of income to the world economy and oil exporters specifically is almost $2 trillion.

In 2013, oil market consumption equaled some 5% of GDP. Across the world at $50, the value falls to just below 2.5%. Net oil importers including the UK are beneficiaries. China, India, US and Japan benefit from the price falls.

Oil exporters are the obvious losers. OPEC, Russia, Venezuela, Canada and Nigeria some of the obvious losers. For economies with internal or external deficits, the problem is particularly acute. Loss of revenues, capital flows and debt service capability, lead to currencies under pressure increasing volatility at a time of a dollar revanche. Fiscal deficits lead to reductions in state spending and pressure on domestic incomes.

But even in advanced economies, net importers of oil will face deflationary effects. Lower prices lead to a loss of fiscal revenues. The overall impact on the world economy is at best a zero sum game. The overall impact may be more deflationary (rather than expansionary) than we would care to accept.

Will prices stay low for long?
The January STEO (short term economic outlook) from the authoritative EIA suggests oil prices will average $58 dollars in 2015 rising to $67 dollars in Q4 and averaging $71 dollars in 2016. If this is the case, the deflationary (price) impact on the UK, US and Europe will continue over the first half of the year with negative CPI rates appearing and persisting well into 2015.

But will low prices persist? Adam Smith suggested “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.”

It is time for the oil producers to have that conversation. The problem for oil is not demand. The world economy will grow by 3% this year and oil consumption along with it. The issue is supply and specifically the increase in US output. The increase over the last two years is not huge in world terms, it has a less than 2.5% significance for output expansion.

The loss to the producers from the oil price fall is almost $2 trillion. The loss to OPEC is $600 billion. It would be cheaper to pay the US frackers to just stop fracking. Tipping over the honey pot to keep another bear out of the game is no solution for OPEC, nor for the world economy for that matter. The oil price collapse is a disproportionate response to the change in supply condition.

So what of UK prices?
Consumer prices CPI basis fell to 0.5% in December, driven lower by energy, petrol and food costs. The CPI 12-month rate was previously 0.5% in May 2000. Food prices fell by 1.9% and prices of motor fuels fell by 10.5%.

Should we worry about UK deflation? Not really. Service sector inflation was 2.3% in the month. The slow down was marked in goods prices, falling by 1%. Economic theory and tabloid wisdom would have us believe deflation is a bad thing. Lower prices lead to a negative economic spiral. Households postpone purchases in anticipation of future price falls. Businesses suspend investment, job lay offs ensue. Unemployment leads to lower demand and off we go in a negative downward spiral.

Significant price falls are in food and petrol. Hardly likely to lead to a delay in the purchase decision. Significant prices rises are still occurring in the service sector. Heavy smoking book worms, with kids at private school, the particular losers in the December inflation story. Tobacco prices increased by 8%, books and education increased by 10%.

Lower prices will lead to a significant boost to real incomes in the short term. Lower prices will benefit the UK economy as we explained in our mid week post. Should we worry about deflation?

Producer Prices …
Output prices by UK manufacturers fell 0.8% in the year to December, compared with a fall of 0.6% in November. This was due to falling prices for crude oil, petroleum and food products. Input costs fell by almost 11%.

With oil trading at $50 per barrel Brent Crude basis and with food and commodity prices still under pressure, the benign outlook for manufacturing costs is expected to continue over the first half of 2015 reducing the pressure on output and retail prices.

So what happened to Sterling this week?
Sterling closed unchanged against the Dollar at $1.515 but moved up against the Euro to 1.311. The Euro closed down against the Dollar at €1.155 from 1.83.

Oil Price Brent Crude closed steady at London close at $49.48 from $49.73. The average price in January last year was $108.126.

Markets, split. The Dow closed at 17,392 from 17,776 on weak retail sales reports but the FTSE closed up just, at 6,550 from 6,501.

UK Ten year gilt yields moved to 1.54 from 1.61 before the break. US Treasury yields fell to 1.82 from 1.98. Gold closed at $1,276 ($1,219).

That’s all for this week. Check out the Oil Market Update. Don’t miss the Great Manchester Business Conference in March and the Economics Conference coming to Manchester in October. It’s a great line up for both events!

John
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