Oil price drop's good and bad news

The Australian

Australians spent about $45 billion on petrol and diesel fuel last year, and stand to make savings of almost $10bn this year if the price falls to date carry through 2015.

It is hoped households, which account for about 60 per cent of fuel usage, spend this windfall and that businesses, which use the rest, feel able to employ more staff and commit to investments because of the boost to profits.

In the US, where petrol prices have fallen by a third, compared with a quarter in Australia, the savings add up to $160bn over a year, enough to make a real difference to the American and world economies.

However, much depends upon whether the prices of oil, along with other resource commodities, are falling mainly because of rising supplies or because demand is weak. If prices are falling mainly because of rising supplies, it is equivalent to a tax cut for consuming countries (though a tax increase for exporting nations such as Australia) and should stimulate ­activity.

If low prices are a symptom of demand that is falling for other reasons, the gains are unlikely to be spent, and the fall in commodity prices adds to the concerns about the danger of deflation. Inflation levels fell around the world last year.

In practice, there is an element of both supply and demand at work. The International Monetary Fund's chief economist, Olivier Blanchard, has done some simulations to measure the possible effects flowing from the fall in oil prices. He estimates 60 per cent of the price fall is due to increased supply. If so, world growth would be higher by between 0.3 per cent and 0.7 per cent over 2015 and between 0.4 per cent and 0.8 per cent next year. The high estimates ­assume the price fall is maintained, while the low estimates are based on prices regaining ground.

The impact varies among countries. The IMF estimates China is a major beneficiary, with growth as much as 0.7 per cent higher than otherwise this year and 0.9 per cent higher next year.

“Overall, lower oil prices due to supply shifts are good news for the global economy, obviously with major distribution effects between oil importers and oil exporters,” a blog posting by Blanchard and ­fellow IMF researcher Rabah Arezki says.

The sources of increased supply are easy enough to see. The rise of non-conventional oil supplies, principally from the US, are adding 4 million barrels a day to world production, now reaching 93 million barrels. Political strife in the Middle East and Libya have caused less disruption than anticipated. OPEC's decision to maintain its production ceiling of 30 million barrels a day despite the emerging glut and record inventories was the immediate catalyst for the abrupt price falls in the final six weeks of last year.

However, weak demand is also a factor. One of the leading oil economists, University of California's James Hamilton, notes that estimates of oil demand by the International Energy Agency for the third quarter of last year are 800,000 barrels a day lower than it was estimating in June. “The suddenness of this shift suggests that economic weakness in Europe, Japan and China made a contribution,” he says.

Even in the US, where the economy has been strengthening, demand has been weaker than expected, partly, Hamilton speculates, because of the decline in labour force participation rates by prime-aged men -- “people who don't have jobs don't drive as much” -- and also because of the ageing of the population.

Hamilton points to the decline in bond yields as an indicator of expected weak demand. Despite the fall in jobless rates and anticipation that the US Federal Reserve will start raising short-term rates by the middle of this year, US 10-year bond yields have come down from 2.5 per cent to 2.17 per cent in the past three months, as oil prices were also sliding.

Prices for copper -- often seen as an indicator of global industrial health -- have also been falling, although not nearly as severely as oil. Copper prices are down by a little over 10 per cent in the past three months. Hamilton estimates that based on historic relationships of the oil market with copper prices, bond yields and the US dollar, weakness in demand is behind 45 per cent of the fall in oil markets.

For Australia, the issue comes into sharpest relief with China, the market for 35 per cent of our exports. The decline in Australia's terms of trade (export prices compared with import prices) is bringing weak national income in its train, with per capita income actually falling now for two years. Our loss is China's gain: its terms of trade have risen by about 25 per cent since commodity prices started falling in 2011 and are up about 8 per cent on the past year.

This is additional windfall income to Chinese households, businesses and government. It is striking that China is struggling to sustain its growth despite this boost to income. A strong yuan and improved purchasing power have not brought a lift in imports, which were 6.7 per cent lower in November than a year earlier. This is indicative of the headwinds China's economy is facing.

Steel production is 2 per cent lower in the 12 months to November than a year earlier -- the first such fall in 31 years. Steel exports are up about 50 per cent as mills look for alternatives to the declining domestic market.

China's central bank has cut rates and more official efforts to support demand are expected. They may stabilise the property market, which has been the main source of weakness. So far, however, falling prices are symptomatic of broader issues in the Chinese economy that are overwhelming any positive effect from lower commodity prices.

The response in the US may be quite different, with consumers tempted to spend and businesses hire. Globally, the IMF's index of all primary commodities (including food, energy and minerals) is down 20 per cent since the June quarter. The fund's estimates of world growth for 2014 were marked down over the year and have been downgraded from 3.7 per cent at the beginning of the year to 3.3 per cent in its October forecast. However, there has only been a small change in its estimate for this year, which it says will bring a lift to 3.8 per cent.

The fund will update these forecasts in the next few weeks, and will have to make a call on whether the falls in commodity prices since October will raise growth or be overwhelmed by the increasing signs of weakness in the major economies outside the US.

This article was first published in The Australian. Reproduced with permission.