Wednesday, May 12

Economic Impact Of Oil Price Fluctuations; Opportunities And Challenges From Revenue Diversification Perspective – Moshood Olajide

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Wide fluctuations in oil prices globally have played an important role in driving recessions and even regimes collapsing—which is why oil price movements are closely watched by investors, and policymakers. The two recent cycles of historic highs and lows suggest that the world economy is in unchartered territory.

In 1973, Egypt and Syria waged a surprise war on Israel, which soon divided many countries into supporters of either side Subsequently, several oil-exporting Arab nations curtailed oil production (known as “the oil embargo”), quadrupling oil prices within a quarter. This oil crisis was one of the biggest factors that pushed some oil-consuming, industrialized nations such as the United States and the United Kingdom into an economic recession that lasted over a year. History repeated itself when disruptions in Iran’s oil production during the Iranian revolution, followed by the Iraq-Iran war, caused oil prices to skyrocket in 1979–80. This time, in addition to a supply shock, increased inventory demand in anticipation of supply shortages and rising global demand contributed to the oil price rise. The price shocks had a substantial impact on US GDP, and the US economy went into a recession.

Also, contrary to phony theories that Mikhail Gorbachev work towards the weakening and eventual collapse of the USSR in alignment with United States, The timeline of the Soviet Union collapse can be traced to Saudi Arabia deciding to stop protecting oil prices and increasing production fourfold in 1985. The sudden fall in oil prices was one of the key factors that weakened economic fundamentals of the Soviet Union. The region lost approximately $20 billion per year due to lower revenues from oil exports, which resulted in huge government borrowing in the following years. By 1989, the Soviet economy had stalled.

In recent months, oil prices have shown signs of a recovery, after touching a low of $26 per barrel in January 2017 which forces the Nigerian government to cut expenditure. While many forecasters are optimistic about the recent price rise and are predicting that the oil glut may be over, some are concerned that there is a lot of uncertainty surrounding the current rebound. The direct influence of the Organization of Petroleum Exporting Countries (OPEC) on oil prices has changed due to rising competition from US shale oil producers. Instead of defending price levels, OPEC has changed its strategy to defend market share rather than price, by producing more at low prices. This supply strategy has been a critical factor in the current oil price trajectory. On the other hand, uncertainty in global demand poses downside risks to oil prices. The question everyone is asking is, “By how much and how soon will oil prices go up?” While oil prices are expected to rebound to $58 per barrel in the next couple of years, they are unlikely to reach the previous high of $100 per barrel anytime soon.

Historically, volatility in oil prices is often explained by shocks to demand and supply of oil arising from any combination of business cycles, geopolitical factors, the discovery of new fields, or technological changes. The past one-and-a-half decades have witnessed an interplay of all these factors, resulting in extreme oil price Fluctuations.

Oil prices surged during 2003–2008 due to an unexpected global economic boom, especially in emerging Asian economies such as China and India, while oil producers failed to keep up with the rising demand. Post May 2007, rising inventories in anticipation of increasing demand added to the existing demand pressures. Within a year, oil prices nearly doubled, reaching $113 dollars in May 2008.

After a brief fall in oil prices during the 2008 financial crisis, prices quickly picked up by mid-2009 on the back of strong growth in some of the emerging nations. The political uprising and civil wars in a few Middle Eastern countries resulted in intermittent oil supply disruptions. Oil prices reached $100 per barrel in 2010 and remained steady at $90–120 per barrel during 2011–2014.

All this changed, however, when oil prices dropped over 70 percent between June 2014 and January 2016 till now, as supply outstripped demand while Post 2014, Libya and Iraq’s faster-than-expected resumption of oil production; US energy companies’ resilience in continuing supply despite falling prices; and increased production by Canada, Russia, and, lately, Iran after sanctions were lifted led to a sustained increase in oil supply.

However, the biggest contributor has been Saudi Arabia’s (the biggest oil producer within OPEC) unwillingness to not counter the increasing supply but instead maintain the production at historically high levels despite the perceived glut. Its intention might have been to preserve market share at the expense of Iran and the United States, even if that meant lower prices.

Meanwhile, global growth slowed because of the economic slowdown in China; modest growth in most of the advanced economies, including the United States; and increasing uncertainty in the Eurozone—leading to a steady fall in oil consumption growth by these big oil importers. Slowing demand growth amid rising supply resulted in a sharp increase in inventories during 2014– 2015. By the end of January 2016, oil prices slid to $26 per barrel—the lowest level since 2003.

Consequently, crude oil production in the United States has started declining. While Iran, Saudi Arabia, and Russia have continued to boost oil production, unplanned supply disruptions due to production outages in a few countries, as Nigeria, Canada, and Venezuela, have impacted the overall oil supply, and there prices.

Much has been made of the alleged role of speculative trading in oil futures markets and hedging in determining oil prices, especially when oil prices touched record-high levels in 2008 or when they were in free fall post 2014. However, there is no significant evidence justifying this argument.

Lower oil prices will result in a redistribution of resources. Gains will likely be spread across many economies, while losses may be concentrated among a few.

Oil importers: The beneficiaries of persistently low oil prices are likely to be the oil-importing nations, because of improved household consumption spending, business investment as production costs fall and profits increase, and external accounts. Low oil prices also provide these nations an opportunity to cut down energy subsidies, which improves fiscal balance overall but reduces the benefits accrued to households and businesses.

Within oil importers, nations that are experiencing high inflation (primarily emerging nations) are likely to benefit from falling import prices, which put downward pressure on both core and headline inflation. On the other hand, persistently falling oil prices do not bode well for nations that are battling deflationary pressures (primarily advanced nations). Major advanced nations, such as Japan, the United States, and those in Europe, have implemented unconventional monetary policies, and falling oil prices may complicate the conduct of such policies. These economies are constrained by interest rates that are either near zero or negative, so they cannot offset the deflationary impact of falling oil prices by reducing interest rates further, as they could have done in normal times. In order to anchor deflation, these economies may have to rely on forward guidance by monetary authorities for the medium term, extending the duration of the unconventional monetary policies, or both. However, prolonged implementation of unconventional policies may lead to greater economic and financial uncertainty in the long run.

Oil exporters: Oil-exporting nations will likely be adversely impacted as real income goes down and profit margins for oil producers get stressed. Energy companies’ weak financial positions may deteriorate the balance sheets of the financial institutions that lend to these companies and thus may threaten the financial stability of these economies. At the same time, the governments will likely take in less revenue, and their budgets and external balances are expected to come under pressure.

That said, the impact of falling prices on oil exporters will differ depending on the contribution of oil exports to each country’s GDP and revenue. Growth in economies such as Venezuela and Angola is highly dependent on oil exports (relative to Russia and Saudi Arabia), and any vulnerability in oil prices is likely to have a severe impact on their economic activity. Similarly, in many countries, oil revenues account for more than 50 percent of total government revenues—for a few countries such as Iraq and Qatar, the share is as high as 90 percent.

The International Monetary Fund (IMF) estimates the break-even prices at which Middle Eastern and Central Asian countries can balance their fiscal and external accounts. Prices below these break-even levels may result in severe fiscal and external account deficits, which may affect the valuation of the local currency, inflation, and existing debt.

Price instability intensifies economic uncertainty, and this impact is generally more pronounced in nations highly dependent on oil exports. The tight demand-supply balance for oil along with external shocks, such as political and policy shifts in the United States, Nigeria and Europe, may result in sustained pressure on oil price stability.

Given the uncertainty, oil exporters such as Brazil and Russia might benefit from undertaking structural reforms as well as adjusting fiscal and monetary policies, with the speed of adjustment determined by the extent of vulnerabilities. Reforms in the financial sector and strengthening the private non-commodity sector could help boost non-oil growth.

In the long term, diversifying the economy away from oil can help cushion the impact of low oil prices and ensure economic stability in the face of extreme oil price fluctuations. Saudi Arabia has already announced a “Vision 2030” reform program that aims to lessen the country’s dependence on the public sector to foster private sector entrepreneurship. The government is also taking steps toward improving the educational system to enhance skills that could promote diversification. These measures, if successful, may help Saudi Arabia reduce its dependence on oil. This, in turn, may enable the country to regain its influence over the global oil market, because then hard decisions to continue pumping oil at low prices may not come at the cost of economic deceleration. Similarly, Nigeria has also announced a “zero oil” plan to help the country increase non-oil exports over the next decade. However, the pace and scale of these diversification efforts and their success will depend on a number of factors, including empowerment of the private sector and workers. Only time will tell whether these measures bear the fruit the respective governments expect.


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