Oil prices almost halved from their mid-year level in a swift reversal of their trend upwards because of weak global demand and a boom in production of US shale oil, a close substitute product. This has largely positive implications for the global economy that benefits from increased disposable income because of energy cost savings.
However, the Organization of the Petroleum Exporting Countries (OPEC) has diverged from previous tactics of cutting its oil supply to maintain a high price since it aims to win market share in the long run by pricing out the infant shale producers.
Oil has suffered from weak global demand because of a structural demand shifts away from high polluters and gloomy prospects from high consumers like China, which is entering a phase of low oil intensity growth with its deindustrialization.
The price decline – allowed to continue by OPEC, a cartel whose supposed goal is price stability – is hidden predatory pricing (or a price war) so may be temporary if it manages to bankrupt smaller shale competitors before its own members go bust.
Most of their costs are sunk in initial investment so they could survive with low prices until their current refinery output declines shortly. Shale firms tend to be overstretched in debt so could go bust quickly if investment dries up because of low prices and thus returns.
American shale competitors – a risk-hungry mix of oil engineers, entrepreneurs and investors – are still making big gains in efficiency with a relatively new business model facing tough competitive pressure. Even if they crash now, much like Silicon Valley startups taking on an established tycoon, shale firms are likely to pose a substantial long-term threat to OPEC.
OPEC previously rationed output of oil during the 2008 financial crisis to maintain a high oil price needed to avoid national debt for those – like Venezuela, Iran and Russia – that depend on state oil behemoth’s revenues. Not doing the same now would force these states to find new revenue or add to their debt.
Although OPEC is adding artificial barriers to entry like low prices on top of the natural barriers to entry such as the challenge of competing with experienced state giants, innovative shale firms’ competition bring the benefit of lower energy costs.
The fall in oil prices boosts the profits of energy intensive sectors, but hurts energy producers. More importantly, it shifts roughly two per cent of annual world output from producers to consumers, who are likely to spend the increase in real, disposable income, boosting aggregate demand.
However, this price fall also could reduce worryingly low inflation and turn it into deflation. It increases real interest rates so could intensify the savings glut. This should encourage more monetary easing to combat the threat to feeble aggregate demand. Deflation is not a worry if caused by shale firms’ cost reductions, but is bad if caused by very low global demand.
Nations dependent on energy imports or battling inflation would benefit and most should take the opportunity to cut costly fuel subsidies and intensify carbon pricing, helping balance their budget.
The fall in oil prices would benefit the global economy by transferring cash from inefficient state petroleum producers to dynamic shale competitors and consumers eager to spend. The shale boom’s creative destruction should lead to technical efficiency and more stable oil prices, by curbing the power of OPEC.