Oil prices – an economics lesson with potentially serious outcomes

The fall in oil prices over the last six months has been extraordinary. West Texas Intermediate crude oil, a generally accepted benchmark price,  was trading around US$100 per barrel for the last 5 years, with some volatility, but from August 2014 has appeared to be in free-fall. The price is now just above US$50. Is this excessive volatility ahead of a return to price levels of around US$100 or is it a new normal pricing level? Will it fall further? How will the suppliers react? What happens to the oil price in 2015 is vitally important to the world’s political power plays. In certain scenarios, the potential outcomes are serious.

The immediate effects of the fall in prices are noticeable at the petrol station. It costs quite a bit less to fill the car’s tank when street prices (in Melbourne) have fallen from about 150 cents per litre to 115 cents. Those of us driving V8 engined cars are very happy about that. (Those in their green hybrids are metaphorically fuming, but that is another story.) Cheaper energy prices benefit consumers – heating, cooling, cooking, transport etc all become more affordable. While this allows people relatively rich western societies to spend more on non-essentials, for the poorer societies, it can bring people out of poverty and subsistence living.

For economies that generate national income from the sale of oil, such as the OPEC members, Russia, Nigeria and others, the price fall results in a serious hit to revenues. Oil producers, and the many elements of an economy that service those producers, are going through a very substantial enforced reorganisation to avoid collapse. Nationally, this results in reduced state revenue from falling tax revenues, duties, royalties etc. The adjustment in the labour sector as workers are laid off creates increased pressure for Government assistance payments and other spending pressures. For an economy that is heavily dependent on oil revenue, the benefits of cheaper prices will not be enough to offset the pain of such a hit to GDP.

There has been chatter about the reasons behind the price fall. One of the most bizarre comes from the President of Iran who believes that there is a conspiracy against Islamic countries in the middle east. He fails to nominate who is behind the conspiracy and how it is being effected. Others, such as the President of Russia, believe Russia is the target of pay-back for its meddling in Ukraine. This shows the political pressure those leaders are feeling right now. More convincing are the arguments that point to a shift in the oil supply curve. The technological developments that have allowed the production of shale oil in commercial operations has created a significant additional supply of oil that previously was uneconomic to produce. The bulk of the world’s exploitable oil shale rock is in the US. In previous years, this was known to be a potential alternative supply to crude oil but would only become viable when the crude oil price was much higher, due to dwindling supply. That the supply has come onto the market without the rise in crude oil prices was made possible by technological advancement.  The potential new supply is huge. I mean really huge.

From time to time, technological advancement causes change in the relative fortunes of people such that certain groups in society, even whole cities can have their previous economic advantage wiped out while a new class benefits. The change in shipping practices that was forced by the introduction of the shipping container resulted in a change in the world’s trade balances, wealth and power of enormous significance. The new supply of oil has the potential to similarly disrupt and create. The nervousness in OPEC and Russia shows that they understand this. Almost certainly, OPEC will attempt to manipulate the price by constraining supply, but this is not easy to do successfully and can never work over an extended period.   There will be winners and losers. The bulk-cargo handling facilities of the shipping ports in Liverpool, Glasgow and New York all lost out when the container revolutionised shipping. But Rotterdam, Felixstowe and Los Angeles captured and exploited the technological shift brilliantly.

The dangers in the oil supply revolution, if that is what it turns out to be, are inherently political. Nobody likes losing a position of power and influence. The current suppliers of crude oil to the world will not easily give up some of their privileged status. Investment with technological advancement, specialisation of labour and trade has always been the basis of rising living standards. The incumbent power has less incentive to invest and innovate. When others do, and the incumbent loses its privilege, the time of the adjustment shock is the danger period and the more rapid the adjustment, the greater the danger.