Decoding the oil price fall

Year 2015 will be crucial as shale oil rms begin to feel the pinch of low prices
Raghuvir Srinivasan

re falling oil prices

good or bad for the
global economy?
And how do they
work for India? Till recently
these questions were nobrainers. Cheaper oil is obviously good for the global
economy; for an energy-intensive economy such as Indias, which also depends on
imported oil for meeting
four-fths of its needs, a fall
in oil price is like manna
from heaven.
Yet, the biggest fall in the
stock market in ve-and-ahalf years last week was
triggered by crude oil piercing the $50 a barrel mark on
its unrelenting downward
journey. Isnt that ironic?
The benchmark S&P BSE
Sensex fell by 3 per cent or
855 points in just a single
trading session on January
6. To be sure there were
other causes too such as
fears over Greece exiting
the euro zone and slowdown in China. But yet, the
fact is that global stock markets have been nervous in
the last one month over
sliding oil prices and investors, in their desperation to
nd reasons for the slide,
have somehow arrived at
the conclusion that this is
indicative a global economic slowdown or worse, even
recession.
Nothing can be farther
from the truth though. Yes,
there are issues with the
Chinese economy which is
seeing a slowdown in manufacturing growth (mind you,
this is not the same as a recession) and the euro zones
troubles continue with
Greece headed for snap
polls amidst fear of a run on
its banks. But the positive
impact of falling oil prices
outweighs these worries, at
least at this point in time.
A recent IMF study says
that every $10 fall in oil
price adds 0.2 percentage
points to global GDP
growth. And that should

Pump jacks drill for oil in the Monterey Shale, California. FILE PHOTO: REUTERS
mean a boost of a over 1.2
percentage points to global
GDP growth given that oil
has dropped from around
$115 a barrel six months ago
to less than $50 a barrel
now. So where is the basis
for fear of a global slowdown or a recession?

Anatomy of the fall

It is simplistic to assume
that oil prices are sliding
only because of falling demand. The reality is that the
plunge is due to a complex
interplay of several factors,
including, of course, lower
demand.
The inability, or unwillingness rather, of the Organisation of Petroleum
Exporting
Countries
(OPEC), which accounts for
about 40 per cent of global
oil output, to cut production to match the demand is
a major factor.
OPEC members are
caught in a difficult spot as
cutting down production

will mean loss of revenue.

They are also conscious
about holding on to their
market shares; cutting output will mean a loss of market share, especially if the
U.S. shale gas producers
continue to pump away.
Yet, every barrel that they
are unable to cut is adding
to market surplus and depressing the price.
Saudi Arabia, which dominates the cartel with the
highest share, appears determined to stay in a race to
the bottom along with U.S.
shale oil producers.
The kingdom is gambling
that shale oil will become
economically unviable to
produce if it already has
not as prices head below
the $50 a barrel mark. First
signs of that gamble paying
off are just beginning to appear on the horizon. Drilling activity for shale oil is
beginning to slow down as
producers begin to feel the
pinch of unremunerative
prices. Americas oil output
may now be at a three-decade-high but 2015 will be a
crucial year as shale oil producers begin to cut down on
output.

Demand-supply
equations
If basic demand-supply
equations are one factor for
sliding oil prices, the other
is nancial market equations. The oil market was
funded in a major way in the
last few years by cheap dollars owing out of the Federal Reserves quantitative

easing programme. With interest rates at near zero,

surplus funds owed into
the commodity markets,
notably crude oil, driving
their prices upwards.
With the Fed winding up
its stimulus programme
and an interest rate hike in
the U.S. possibly just round
the corner, funds are now
owing out of commodities,
driving their prices down. It
is not a coincidence that oil
prices started falling at
around the same time that
the Fed rst indicated the
possibility of a rate hike in
the near term.
Oil prices are likely to
stay soft for at least the rest
of this year though periodic
minor spikes cannot be
ruled out. This is, as said at
the beginning of this piece,
good news for the world
economy and also Indias.
Cheaper fuel prices will put
more money in the hands of
consumers which will, in
turn, be either invested or
spent elsewhere.
According to Moodys
chief economist, Mark Zandi, quoted in a recent
Bloomberg report, if oil
stayed at $60 a barrel,
American consumers would
save a whopping $150 billion on their fuel bills
which, according to him,
will be spent elsewhere
driving economic growth.
This would hold true for
other countries as well, including India.
Of course, we are assuming here that governments
across the world pass on the

benet to consumers and

not appropriate it as taxes.
So far as India goes, a lot
depends on how well the
government exploits the
low oil price scenario. For
one, it should use the
chance to clean up its subsidy act once and for all,
mainly in cooking gas and
fertilizers. It should push
for transparency in pricing
of fuel by the oil companies,
something that is now absent.
The government should
also ensure market prices
for the oil producing PSUs
ONGC and OIL so that
they can invest in exploration and production.
It should resist the temptation to raise taxes excise duty has gone up thrice
in the last two months depriving consumers of the
benet of lower prices. To
the contrary, the government should pass on the
benet to consumers who
can then either spend the
surplus elsewhere or save.
Costs across the economy
would also drop acting as a
stimulus by itself if the government cuts fuel prices.
The benets from a larger
macro economic perspective in the long-term would
be bigger than the resources
raised from fresh taxes in
the short-term. We missed
the opportunity to do all
this the last time when oil
prices were at similar levels.
We cannot afford to miss it
again.
raghuvir.s
@thehindu.co.in