Business Journal


The IMF perspective: 7 Questions on Oil Price Slump

oil rig

Oil prices have plunged recently, affecting everyone: producers, exporters, governments, and consumers. Overall, we see this as a shot in the arm for the global economy. Bearing in mind that our simulations do not represent a forecast of the state of the global economy, we find a gain for world GDP between 0.3 and 0.7 percent in 2015, compared to a scenario without the drop in oil prices.

What follows is our attempt to answer seven key questions about the oil price decline:

• What are the respective roles of demand and supply factors?

Oil prices have fallen by nearly 50 percent since June, 40 percent since September (see Chart 1).[2] Metal prices, which typically react to global activity even more than oil prices, have also decreased but substantially less so than oil (see Chart 2). This casual observation suggests that factors specific to the oil market, especially supply ones could have played an important role in explaining the drop in oil prices.

A closer look reinforces this conclusion. Revisions between June and December of International Energy Agency forecasts of demand combined with estimates of the short run elasticity of oil supply, suggest that\ unexpected lower demand between then and now can account for only 20 to 35 percent of the price decline.

On the supply side, the evidence points to a number of factors, including surprise increases in oil production. This is in part due to faster than expected recovery of Libyan oil production in September and unaffected Iraq production, despite unrest.

A major factor, however, is surely the publicly announced intention of Saudi Arabia—the biggest oil producer within OPEC—not to counter the steadily increasing supply of oil from both other OPEC and non-OPEC producers, and the subsequent November decision by OPEC to maintain their collective production ceiling of 30 million barrels a day in spite of a perceived glut.

The steady increase in global oil production could be seen as “the dog that didn’t bark.” In other words, oil prices had stayed relatively high in spite of the upward trajectory in global oil production due to the perception at the time of OPEC’s induced floor price. The resulting shift by the swing producer however helped trigger a fundamental change in expectations about the future path of global oil supply, in turn explaining both the timing and magnitude of the fall in oil prices, bringing the latter closer to the level of a competitive market equilibrium. A similarly dramatic drop took place in 1986, when Saudi Arabia voluntarily stopped being the swing producer, causing oil prices to fall from $27 to $14 per barrel, only to recover fifteen years later, in 2000.

Beyond traditional demand and supply factors, some have pointed to “financialisation”—oil and other commodities considered by financial investors as a distinct asset class—and “speculation” as contributors to the price decline. We see little evidence
that this is the case. According to the latest report from the International Energy Agency, oil inventories have reached their highest level in two years, suggesting expectations of price increases, not price declines.

• How persistent is this supply shift likely to be?

This depends primarily on two factors: The first is whether OPEC, and in particular Saudi Arabia, will be willing to cut production in the future. This in turn depends in part on the motives behind its change in strategy, and the relative importance of geopolitical and economic factors in that decision.

One hypothesis is that Saudi Arabia has found it too costly, in the face of steady increases in non-OPEC supply, to be the swing producer and maintain a high price. If so, and unless the pain of lower revenues leads other OPEC producers and Russia to agree to share cuts more widely in the future, the shift in strategy is unlikely to change soon. Available projections from the same source indicate that capital expenditures will fall markedly throughout 2017.

For unconventional oil, such as shale, (which now accounts for 4 million out of a world supply of 93 million barrels a day), the breakeven prices—the oil price at which it becomes worthwhile to extract—of the main United States shale fields (Bakken, Eagle Ford and Permian) are typically below $60 per barrel (see Chart 5 which gives break-even prices for the United States shale fields).

At current prices (around $55 per barrel), Rystad Energy’s projections suggest that the level of oil production could decline but only moderately by about less than 4 percent in 2015. Rates of return will be significantly lower, however, and some highly leveraged firms that did not hedge against lower prices are already under financial stress and have been cutting their capital expenditure and laying off significantly.

On the demand side, uncertainty about global economic activity and thus the derived demand for oil remains high- the 68% confidence band for the price in 2019 ranges from $48 to $85, the 95 percent band from $38 to $115; a very wide range indeed.

What are the effects likely to be on the global economy?

Overall, lower oil prices due to supply shifts are good news for the global economy, obviously with major distribution effects between oil importers and oil exporters. The crucial assumptions in quantifying the effects of those supply shifts are how large and persistent we expect them to be.

The first assumes that the supply shift accounts for 60 percent of the price decline reflected in futures markets. The second also assumes that the supply shift accounts for 60 percent of the price decline at the start but that the shift is partly undone over time for the reasons described above, with its contribution to the price decline going gradually to zero in 2019.

The results of the simulations shown below capture only the effects of the supply component of the oil price decline (the demand driven component of the oil price decline is a symptom of slowing global economic activity rather than a cause). The oil price projection used in the simulations is based on the IMF’s price forecast, which is itself based on futures contracts.

The first simulation implies an increase in global output of 0.7 percent in 2015 and 0.8 percent in 2016 relative to the baseline (the situation without the oil price drop. Not surprisingly, in the second scenario, the effect on output is smaller, of the order of 0.3 percent in 2015 and 0.4 percent in 2016.

Estimates from Blanchard and Gali (2009) for example find that the effect of a permanent (supply driven) decrease in the price of oil by 10 percent leads to an increase in U.S. output by about 0.2 percent.

Given a supply component of the price decline of about 25% (60% of a total decline of 40%), these estimates would therefore imply an increase in output of about 0.5%.

• What are likely to be the effects on oil importers?

There are three main channels through which a decrease in the price of oil affects oil importers. The first is the effect of the increase in real income on consumption. The second is the decrease in the cost of production of final goods, and in turn on profit and investment.

The third is the effect on the rate of inflation, both headline and core. The strength of these effects varies across countries: For example, the real income effect is smaller for the United States, which now produces over half of the oil it consumes, than for the euro zone or for Japan. The real income and profit effects also depend on the energy intensity of the country: China and India remain substantially more energy intensive than advanced economies, and thus benefit more from lower energy prices. The share of oil consumption in GDP is on average 3.8 percent for the United States, compared to 5.4 percent for China and 7.5 percent for India and Indonesia.

The effect on core inflation depends both on the direct effect of lower oil prices on headline inflation, and on the pass-through of oil prices to wages and other prices. The strength of the passthrough depends on real wage rigidities—the way nominal wages respond to CPI inflation and the anchoring of inflation expectations.

Our simulations reflect, to the best possible extent, these differences in energy intensity, in the proportion of oil produced at home, and in monetary policy constraints. We assume that inflation expectations are similarly anchored in the United States, the euro zone, and Japan, leading to a pass through of about 0.2, so a decrease in core inflation of 0.2 percentage points when headline inflation decreases by 1 percentage point.

For example, low-income importers in the Caribbean that benefit from transfers under Venezuela’s Petrocaribe regime could face a marked reduction in transfers as Venezuela itself comes under pressure. Caucasus and central Asia oil importers are likely to experience adverse spillovers from slowing growth in their oil exporting neighbors, particularly Russia, which will reduce non-oil exports and remittances. Mashreq countries and Pakistan might also be adversely affected through a decline in non-oil exports, official transfers and remittances from the member countries of the Gulf Cooperation Council, especially over the medium-term.

• What are likely to be the effects on oil exporters?

The effect is, not surprisingly, negative for oil exporters. Here again, however, there are substantial differences across countries. In all countries, real income goes down, and so do profits in oil production; these are the mirror images of what happens in oil importers. But the degree to which they do, and the effect of the decline in the price of oil on GDP depends very much on their degree of dependence on oil exports, and on what proportion of revenues goes to the state.

Oil exports are much more concentrated across countries than oil imports. Put another way, oil exporters depend much more on oil than oil importers. To take some examples, energy accounts for 25 percent of Russia’s GDP, 70 percent of its exports, and 50 percent of federal revenues. In the Middle East, the share of oil in federal government revenue is 22.5 percent of GDP and 63.6 percent of exports for the Gulf Cooperation Council countries.

In Africa, oil exports accounts for 40-50 percent of GDP for Gabon, Angola and the Republic of Congo, and 80 percent of GDP for Equatorial Guinea. Oil also accounts for 75 percent of government revenues in Angola, Republic of Congo and Equatorial Guinea. In Latin America, oil contributes respectively about 30 percent and 46.6 percent to public sector revenues, and about 55 percent and 94 percent of exports for

Ecuador and Venezuela. This shows the dimension of the challenge facing these countries.

In most countries, a mechanical effect of the oil price decline is likely to be a fiscal deficit. One way to illustrate the vulnerabilities of oil-exporting countries is to compute the so-called fiscal break-even prices— that is, the oil prices at which
the governments of oil-exporting countries balance their budgets. The breakeven prices vary considerably across countries, but they are often very high.

For Middle Eastern and Central Asian countries, the break-even prices range from $54 per barrel for Kuwait to $184 for Libya with a notable $106 for Saudi Arabia. For countries for which we do not have available data on break-even prices, budgetary oil prices (that is, the oil prices that countries assume in preparing their budget) are another way to gauge countries’ vulnerability to falling oil prices.

For Africa, those budgetary oil prices have been revised down in 2015 in light of the falling prices (See Chart 10). For Latin America, the budgetary oil prices are $79.7 for Ecuador and $60 for Venezuela.

Some countries are better equipped than in previous episodes to manage the adjustment. A few have put in place policy cushions
such as fiscal rules and saving funds and have more credible monetary framework, which have helped decouple internal from external
balances, such as Norway. But, in many, the adjustment will imply fiscal tightening, lower output, and a depreciation (harder to achieve under the fixed exchange rate regimes that characterise many oil exporters). And where expectations of inflation are not well anchored, the depreciation may lead to higher inflation.

• What are the financial implications?

Declines in oil prices have financial implications, directly through the effects of oil prices themselves, and indirectly through the induced adjustment of exchange rates.

Lower oil prices weaken the financial position of firms in the energy sector, especially those that have borrowed in dollars, and by implication weaken the position of banks and other institutions with substantial claims on the energy sector. The proportion of energy firms with an interest coverage ratio (the ratio of cash flows to interest payments) below 2 stands at 31 percent in emerging countries, indicating that some of these companies may indeed be at risk.

Lower oil prices also typically lead to an appreciation of oil importers’ currencies, in particular the dollar, and to a depreciation of oil exporters’ currencies. The drop in oil price has contributed to an abrupt depreciation of currencies in a number of oil exporting countries including Russia and Nigeria.

If sustained, the oil price slump will thus have a concentrated and material impact on those bondholders and banks with high dollar and energy sector exposures. However, the global banking system’s exposure is likely not to be large enough to cause more than a moderate increase in provisioning requirements and should be partially offset by improving credit quality in oil importing countries and sectors.

• What should be the policy response of oil importers and exporters?

Clearly, the appropriate policy response to falling oil prices will depend on whether the country is an oil importer or exporter. The exception is the shared opportunity provided by low oil prices to reform energy subsidies and energy taxes. The IMF has long advocated that governments use the saving from the removal of energy subsidies toward more targeted transfers.[10] Low prices provide a great opportunity to remove subsidies at less political cost.

Now let’s turn to oil importing countries. In normal times, for a country in good macroeconomic health — say, no output gap, inflation is at target and current account is balanced— the advice is well honed, learned from past movements in oil prices: monetary policy should make sure that, in the face of lower headline inflation, inflation expectations remain anchored, and try to maintain stable core inflation.

Whether this implies an increase or a decrease in the interest rate is ambiguous. On the one hand, higher demand calls for higher interest rates; on the other hand, keeping core inflation from declining, may call for lowering interest rates. In general, whatever the interest rate does, the improvement in the current account balance is likely to generate an exchange rate appreciation. This appreciation is nnatural, and desirable. One might think that the appropriate policy response for oil exporters is the same as that of oil importers, but sign reversed. Importers differ however from exporters in two important ways: first, the size of the shock faced by oil exporters as a proportion of their economy is much larger than for oil importers. Second, the contribution of oil revenues to fiscal revenues is typically much higher.

Thus, in all countries, lower fiscal revenues, and the risk that prices remain low for some time, imply the need for some decrease in government spending. In countries that have accumulated substantial funds from past higher prices, allowing for larger fiscal deficits and drawing on those funds for some time is appropriate. This is even more so for exporters with fixed exchange rates, and where the real depreciation needed for adjustment may take some time to achieve.

For countries without such fiscal space, and where room to increase the fiscal deficit is limited, the adjustment will be tougher. Those countries need a larger real depreciation. And they need a strong monetary framework to avoid that depreciation leads to persistently higher inflation and further depreciation. This will indeed be a challenge for a few oil exporters.

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