RCEM: Views on Energy News

While it is true that low oil prices could reduce the cost of manufacturing, thus helping the global economy to grow, it is a short-term benefit as this is offset by a  curtailment of global investment which forces companies around the world to cut spending, sell assets and make thousands, if not millions, of people redundant.

Therefore, it is doubtful whether the steep decline in oil prices would provide a boost to the US economic recovery. While the price decline would certainly provide the equivalent of a sizable tax cut for US consumers, it will deliver a major blow to the increasingly important US oil industry.

And whilst Lower oil prices could boost US gross domestic product’s (GDP) growth by anywhere between 0.75% and 1.5% according to various macro-economic estimates, there are two major downsides to this benefit for the US economic recovery.

The first is that the US economy itself now has a large oil sector. Over the past eight years, as a result of the shale oil revolution, US oil production has increased by 50% from around 6 million barrels a day (mbd) in 2008 to 9 mbd in 2014. But the steep decline in oil prices since July 2014 has reduced US oil production to an estimated 7.18 mbd today and raised net US oil imports by 817,000 barrels a day (b/d) to 7.95 mbd. At a price of oil less than $60/barrel, the shale oil industry is no longer profitable. This is already causing major investment and employment cutbacks in the US oil and gas industry, which is estimated to employ around 2% of the US workforce. It is also raising the risk of major defaults on the $200 billion in loans that have been extended to the domestic shale oil industry. The cost of servicing that debt has also increased exponentially after a number of operators saw their ratings reduced to junk.

The second major downside to the steep decline in international commodity prices is that it plunges into recession major emerging market economies like Brazil, Russia, and South Africa. This adversely impacts on the US and global economic recoveries. According to estimates by the World Bank, a 1% decline in the growth of the BRICS economies (Brazil, Russia, India, China, and South Africa) could reduce global economic growth by as much as 0.4%. More serious still, the sharp slowdown in the economic growth of the emerging market economies could put into question their corporate sector’s ability to service its $5 trillion debt. That in turn could add to the stresses already appearing in the global financial system.

The three leading US credit rating agencies: Moody’s, Standard & Poor’s (S&P) and Fitch have warned that defaults by shale oil-producing companies will rise in 2016 and 2017. Moody’s is already considering downgrading 69 US oil and gas companies.

Today, the American economy is not in a healthy state. During the Clinton era, the US was set to pay off the entirety of its debt by 2011 with $2.3 trillion to spare; as of June 2016, total federal debt was at $19.23 trillion. This is 107% of an estimated US GDP of $17.91 trillion in 2015. The culprits behind America’s economic deterioration are oil and unwise policy decisions.

Under the Bush Administration in 2001, the decline of the US economy has been due to a combination of extravagant tax cuts and defence expenditures that caused an explosion in federal debt. Funding the tax cuts alone through deficit spending cost the federal government some $379 bn in interest payments while spending on the Iraq war cost the Bush administration at least $6 trillion.

America invaded Iraq with hopes of obtaining large quantities of cheap oil, but those dreams were quickly crushed when crude prices spiked from $25/barrel at the onset of hostilities to upwards of $147/barrel in 2008. The Iraq war was responsible for roughly 63% of the rise. The great recession of 2008 was a direct result of the oil price spike. Although high oil prices were not the sole cause of the recession, they worsened the economic decline triggered by the housing crisis in the US and thus amplified temporary weakness to full-out recession. The indirect costs alone to America were $3.42 trillion in GDP, close to what the Bush tax cuts added to the federal debt.

Oil prices as low as $50/barrel and as high as $147/barrel both adversely and probably equally impact on the US economy and the global economy. If this is the case, then it begs the question as to what price of oil is deemed fair to both the global economy and the oil producers. In my opinion, a price range of $100-$130/barrel could be beneficial for both. Such a price range would enhance global investments and boost spending by the global oil industry which needs a price ranging from $125-$135/barrel to balance its books. It will also boost the revenues of oil producers and enable them to expand their production capacity to meet global oil demand.  

The US Federal Reserve Bank should pay close attention to the negative fall-out from the current low oil and commodity prices on the US economy and the emerging market economies. It should not be in a hurry to raise US interest rates three to four times in 2016, as it presently seems to be contemplating.

Dr Mamdouh G. Salameh
Visiting Professor
ESCP Europe Business School

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