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. Continue reading