Cheap oil for change

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.