Cheap oil for change

Financial Mirror (Cyprus) - - FRONT PAGE -

The re­cent decline in oil prices is likely to have a ma­jor, largely pos­i­tive im­pact on the global econ­omy – even greater than most ob­servers seem to recog­nise. In­deed, if gov­ern­ments take ad­van­tage of lower oil prices to­day to im­ple­ment crit­i­cal en­ergy-pol­icy re­forms, the benefits may im­prove struc­tural fea­tures of their economies to­mor­row.

A key rea­son why the price decline’s im­pact has so far been un­der­es­ti­mated is that no­body knows how long it will last. And, in­deed, past price move­ments pro­vide lit­tle guid­ance in this re­gard. When prices plunged in 2008, they shot back up al­most faster than ex­perts could say “new nor­mal”; af­ter the 19861987 drop, prices re­mained low for a decade and a half.

This time, the price tra­jec­tory is likely to be determined by a new player in the en­ergy game: shale oil. The mar­ginal cost of shale-oil pro­duc­tion (the ex­pense of con­tin­u­ing to pump an ex­ist­ing well) varies from $55 to $70 per bar­rel. Add a $5 profit mar­gin, and the oil-sup­ply curve now has a long, nearhor­i­zon­tal seg­ment in the range of about $60-75 per bar­rel. Re­gard­less of de­mand, this will be the nat­u­ral nest­ing range for the price of oil – call it the “shale shelf” – and will likely re­main in place for a pro­tracted pe­riod.

This pro­vides some in­sight into OPEC’s de­ci­sion last Novem­ber not to cur­tail sup­ply. Saudi Ara­bia cor­rectly rea­soned that cut­ting out­put would not boost prices, but sim­ply con­cede space for new play­ers to step in and grab mar­ket share.

Of course, this pat­tern could be dis­rupted, if, say, a war or ma­jor con­flict in an oil-ex­port­ing re­gion con­strained sup­ply enough to cause prices to spike be­yond the shale shelf. But, in the ab­sence of a ma­jor un­ex­pected shock, oil com­pa­nies will re­main un­der pres­sure to con­tinue sell­ing oil, even at low prices, as they strug­gle to ser­vice the large debts they in­curred on in­vest­ments when oil prices were high. This pres­sure is pre­cisely what drove oil prices so low in De­cem­ber and Jan­uary.

Given this, it is rea­son­able to ex­pect the oil sup­ply to re­main plen­ti­ful, and prices to re­main mod­er­ate, through 2016 – a trend that will boost global growth by an es­ti­mated 0.5 per­cent­age points over this pe­riod. The im­pact will be es­pe­cially large for coun­tries like In­dia and In­done­sia, where the bill for oil im­ports amounts to as much as 7.5% of GDP. In fact, In­dia’s cur­rent ac­count, which has been in deficit for years, is likely to record a sur­plus this year.

This cre­ates a unique op­por­tu­nity for en­ergy-pol­icy re­form. In far too many coun­tries, fuel is heav­ily sub­sidised, strain­ing gov­ern­ment bud­gets and en­cour­ag­ing waste­ful con­sump­tion. Low oil prices of­fer an ideal open­ing to re­duce sub­si­dies, thereby re­leas­ing funds that gov­ern­ments can spend on ba­sic ser­vices and so­cial-wel­fare pro­grams that ad­vance poverty re­duc­tion.

But ad­vis­ing coun­tries sim­ply to lower sub­si­dies is of­ten mean­ing­less. In coun­tries where the gov­ern­ment dic­tates gas prices – like In­dia and In­done­sia did un­til re­cently (and, to some ex­tent, con­tinue to do) – lower mar­ket prices would re­duce the sub­sidy au­to­mat­i­cally. That is why hold­ing down sub­si­dies is in­ad­e­quate for such coun­tries.

The goal should be to shift from a fixed-price sys­tem, with oc­ca­sional gov­ern­ment-de­creed ad­just­ments, to a mar­ket- based price regime, in which the gov­ern­ment makes a cred­i­ble pledge not to limit prices, with the ex­cep­tion of pre-de­fined ex­treme cir­cum­stances. While such a move would have a neg­li­gi­ble ef­fect on prices now, it would pro­vide coun­tries with a huge ad­van­tage dur­ing fu­ture oil-price fluc­tu­a­tions, be­cause con­sumers and re­tail sup­pli­ers would no longer be cut off from price sig­nals.

Amid all of this good news, two se­ri­ous con­cerns stand out. In the short run, de­clin­ing oil prices cre­ate grave chal­lenges for those who, hav­ing in­vested in ex­pand­ing pro­duc­tion when prices were high, now face large costs and fail­ing busi­nesses. More prob­lem­atic, lower oil prices en­cour­age ex­ces­sive con­sump­tion – the long-term en­vi­ron­men­tal im­pact of which will be com­pounded by the weak­en­ing in­cen­tive to in­vest in al­ter­na­tive en­ergy sources.

Pol­i­cy­mak­ers must recog­nise th­ese risks, and im­ple­ment poli­cies to mit­i­gate them. Specif­i­cally, gov­ern­ments should di­vert the money they save on oil and sub­si­dies to tar­geted pro­grams aimed at help­ing peo­ple es­cape poverty, and they should in­cor­po­rate into their tax regimes in­cen­tives for in­no­va­tion and in­vest­ment in clean en­ergy.

With the cor­rect ap­proach, to­day’s oil-price volatil­ity could turn out to be a crit­i­cal turn­ing point on the path to­ward a more sus­tain­able fu­ture, characterised by shared pros­per­ity and gen­uine progress on poverty re­duc­tion. The di­rec­tion to take is clear.

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