ecONOMIC & CONSUMER CREDIT ANalYTICS ANALYSIS �� The Economics of Lower Oil Prices January 2015 The Economics of Lower Oil Prices Prepared by Abstract Chris Lafakis [email protected] Since mid-2014, crude oil prices have dropped precipitously. After averaging more Senior Economist than $100 per barrel in the first half of the year, West Texas Intermediate has plunged Adam Kamins to less than $55 per barrel at year’s end, about a 50% drop. This ranks as one of the [email protected] largest oil price declines in history. And though it will result in economic winners and Senior Economist losers, on net it will be a significant positive for the global economy. Edward Friedman [email protected] Director Dan White [email protected] Senior Economist Contact Us Email [email protected] U.S./Canada +1.866.275.3266 EMEA (London) +44.20.7772.5454 (Prague) +420.224.222.929 Asia/Pacific +852.3551.3077 All Others +1.610.235.5299 Web www.economy.com ANALYSIS �� The Economics of Lower Oil Prices BY CHRIS LAFAKIS, ADAM KAMINS, EDWARD FRIEDMAN AND DAN WHITE ince mid-2014, crude oil prices have dropped precipitously. After averaging more than $100 per barrel in the first half of the year, West Texas Intermediate has plunged to less than $55 per barrel at year’s end, S about a 50% drop. This ranks as one of the largest oil price declines in history. And though it will result in economic winners and losers, on net it will be a significant positive for the global economy. This article addresses four increase. On the supply side, the oil industry in the 1986 oil price drop will be reviewed in broad questions: has become a larger segment of overall busi- this context. 1. What is the baseline outlook for ness fixed investment in the past decade, and Finally, commentary is provided on oil prices? the pace of such investment is sensitive to the effects of lower oil prices in the rest of 2. What are the links between oil and the oil price. the world. the rest of the economy in terms This paper then reviews the intersection of demand, supply, inflation and of oil prices and inflation. Oil prices directly Sharp declines in the past monetary policy? affect the top-line CPI and consequently will The price of oil is especially volatile (see 3. What is the effect of oil prices on affect monetary policy deliberations regard- Chart 1). Three times during the past 35 global, U.S. and regional econo- ing the normalization of interest rates. years, the price of West Texas Intermedi- mies under the baseline outlook for Finally, the effects of lower oil prices ate crude has fallen by more than 40% (see oil prices? on the U.S. economy are evaluated under Chart 2). The biggest decline was in the sec- 4. What would be the impact if oil pric- alternative assumptions that would keep the ond half of 2008, when WTI fell from $133 es were to remain lower for longer? price of oil subdued for several years running. per barrel on a monthly average basis to The article begins by exploring the fac- This projection utilizes the Moody’s Analyt- $40, a 70% drop. That was exclusively a de- tors that explain why oil prices have fallen, ics macro model, a large, multi-equation mand-driven event associated with the rapid including the unexpectedly large recent structural econometric model that links the global contraction in the Great Recession. growth in supply, weakness in global demand various sectors of the U.S. economy. The re- An earlier large decline, starting in late growth, the rising value of the U.S. dollar, gional pattern of impacts is projected using 1985 and continuing through the first half and the perception that political uncer- the Moody’s Analytics regional econometric of 1986, may compare more closely with tainty in global oil-producing regions has models, which use diminished, even though it is not completely the macro model Chart 1: Oil Prices Are Highly Volatile gone. The discussion of these factors will results as inputs % change yr ago underpin the baseline outlook that oil prices to apportion the 150 20 West Texas will remain low in 2015 but rebound steadily effects across the 125 Intermediate, 15 to more than $100 per barrel by 2018. The regions. Most parts 100 $/barrel (L) dynamics are that lower prices will slow the of the country will 75 CPI (R) 10 growth in oil supply at the same time that benefit from a lower 50 5 they lead to higher oil demand. oil price, since they 25 Next, the major linkages between oil and are net consumers 0 0 the overall economy are described. On the of energy. How- -25 -5 demand side, changes in oil prices result in ever, producing -50 significant changes in disposable income regions are at risk -75 -10 available for nonenergy consumer spend- to decline. The ex- 80 85 90 95 00 05 10 ing, qualitatively comparable to a tax cut or perience of Texas Sources: EIA, BLS, Moody’s Analytics MOODY’S ANALYTICS / Copyright© 2015 1 ANALYSIS �� The Economics of Lower Oil Prices Chart 2: Not the First Time Oil Has Fallen So Far Chart 3: Primary Reason Is New Supplies… West Texas Intermediate, peak-to-trough % change Cumulative change in oil production from Dec 2013, mil bpd 0 1.0 Saudi Arabia Iraq Libya U.S. 0.8 0.6 -25 0.4 0.2 -50 0.0 -0.2 -75 -0.4 Nov-85 to Jul-86 Jun-08 to Feb-09 Jun-14 to Dec-14 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Sources: EIA, Moody’s Analytics Sources: IEA, EIA, Moody’s Analytics current events. At that time, the per-barrel Eagle Ford and Bakken shale formations in can be attributed to weaker than expected price fell from a bit higher than $30 to less Texas and North Dakota have been the big- global demand. than $12, a 62% decline. Then, as now, the gest sources of U.S. oil production growth. Specifically, concerns about the global U.S. economy had been recovering for sev- Furthermore, Libyan oil production has economy have widened over the past few eral years from a deep recession, and supply- surged. Because of political infighting, the months. Although China is expected to be side rather than demand-side considerations nation’s production in June was just 240,000 the foremost driver of global oil demand were the major driver. In particular, the gov- bpd, far below its level of 1.5 million before over the next five years, its property prices ernment of Saudi Arabia, the world’s major the 2011 revolution. But since June, the are falling, and recent economic indicators swing producer at the time, found itself in government has cut deals with rebels and have imperiled its target real GDP growth deficit and needed to boost production to protesters, allowing it to reopen oil fields and rate of 7.5%. meet its fiscal needs. terminals. Libyan oil output briefly rose to Moreover, the widening rift between 810,000 bpd before settling at 690,000 bpd. Russia and the West has created a crisis in The supply side today Libyan officials are expecting to boost pro- Russia, which almost assuredly will fall into Moody’s Analytics estimates that ap- duction to 1.2 million bpd by early 2015. recession in 2015. Europe’s growth is slug- proximately half of the recent decline in oil Iraq’s oil production has risen by gish as well. The persistent focus on fiscal prices can be attributed to strong growth in 200,000 bpd since the start of 2014, a re- austerity, constrained credit flows, and a global crude oil production concentrated in markable feat in the midst of the rise of ISIS. lack of structural reforms have kept alive the U.S., Libya and Iraq (see Chart 3). U.S. oil Combined, the U.S., Libya and Iraq added 1.7 fears of a triple-dip recession there. production has risen by 677,000 barrels per million bpd to global oil supply in 2014. Latin America is slumping as well, as both day since June and 978,000 bpd since the Brazil and Argentina have struggled to post beginning of the year, thanks to the contin- Perceived slowing global demand any growth, and Mexico has not performed ued development of oil-rich shale fields. The New supplies have emerged at a time much better. when expectations It is important to note that, up to this Chart 4: …But Weaker Growth Also Plays Role... for global oil de- point, global oil demand continues to grow IEA forecast for 2015 oil demand, change from peak, mil bpd mand growth have despite the dark clouds on the global eco- 0.0 slowed. In recent nomic horizon. But investors worried about months, the Inter- future oil demand gains have flocked toward -0.1 national Energy the exits. Agency has cut its -0.2 forecast for global Other factors oil demand in Moody’s Analytics estimates that appre- -0.3 2015 by 700,000 ciation of the U.S. dollar accounts for about bpd (see Chart 15% of the decline in crude oil prices (see -0.4 4). Moody’s Ana- Chart 5). The dollar has been strong because China OECD Other Emerging Middle East lytics estimates global weakness has led to yet another flight Asia that 30% of the to the safe haven of U.S.