The paradox of the price of oil

 Lawrence Zammit's article on The Times of Malta

The price of oil has gone down to around 30 us dollars a barrel. We have not seen such prices since 2003. As an aside (which I just cannot help making), I wish I had those prices when I was chairman of air Malta. At one stage the price had reached five times that amount!! I admit that this was the proverbial red herring but it leads me to the point of today’s contribution. Why is it that when the price of oil is so low, financial markets view it very negatively, just like when it went well over the 100 us dollars a barrel?

In fact let us go back to the year (early 2008) when the price of oil hit the 100 us dollars a barrel. Then demand for oil was outstripping supply, reflecting the economic boom in Asia, especially china. It also reflected the investment made by hedge funds in oil futures. Then there was the fear that the price would trigger a recession as the price oil edged towards 150 us dollars during 2008, leading to costs of production rising and consumer demand falling.

The global economy did in fact move into an international economic recession around twelve months later. However this was more caused by the turmoil in the financial markets caused by the collapse of Lehman brothers (whoever still remembers the name of that bank) and the resultant credit crunch than by anything else. In fact soon after the price of oil started coming down.

So why is it that when the price has fallen so much, financial and economic analysts are not elated as they are fearing a recession. There is definitely an over supply oil which is resulting from economic warfare against the production of shale gas and the production of energy from renewable resources, which will make the developed countries less reliant on oil.

The lower the price of oil the less financially viable would be its substitutes. So it is in the interest of oil companies and oil producing countries not to weaken the competition. Let us keep in mind the climate deal struck in Paris late last year, which has committed countries to reduce emissions that are contributing to global warming. A low price of oil would make it tempting for countries to postpone the introduction of measures to reduce co2 emissions.

There are also political issues. To what extent is the production of oil financing the conflicts in the Middle East? With the sanctions on Iran now being lifted, will production of oil increase further? Where is the oil being produced in areas that are controlled by ISIS going?

On the other hand demand for oil has also fallen, with the adjustment process currently going on in the Chinese economy. Production activity that is reliant on oil has gone down there. It has also gone down in other countries such as Brazil. So a fall in the price of oil is also seen as a fall in aggregate demand, thereby indicating an economic slowdown. The fall in the price of oil has also led to the containment of inflation in several countries, especially those that import most of their energy requirements.

So if the fall in the price of oil is reflective of falling aggregate demand and lower output levels, then one can understand why economic and financial analysts are worried about it.

This situation has been compounded further by the fact that governments on several developed economies have not passed on this reduction in the price of oil to the consumers. They have raised the excise duty on oil products such as petrol, in order to generate a windfall in public finances.

They are trying to address the fiscal deficit and high levels of public debt on the back of the decrease in the price of oil. Thus consumers in such economies have not had the full benefit of the fall in the price of oil, and as such have not had any significant impact on their purchasing power. Thus consumer demand is not taking off, as it should have in such circumstances.

Therefore we are in a situation where the lowering of the price of oil should have pushed up investment and consumption; but it has not. One should also remember the low level of interest rates that should also have helped to stimulate investment and consumption. It remains to be seen whether this situation is sustainable or whether governments will rue the day that they have missed a golden opportunity to kick start their respective economies.

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