Nicole WillingThe US benchmark crude oil price turned negative for the first time in history in April and while the market is rebounding now, it remains below the long-term average. In this time of an unprecedented global pandemic, the economic effects of low oil prices are particularly acute.
Many people are now wondering: Why are low oil prices bad for the economy, when they can translate to lower fuel prices for businesses and consumers?
This article looks at the impact of falling oil prices on global economy metrics, to provide some context for the current market moves.
The role of crude oil in the global economy
Crude oil is a key determining factor of the overall health of the global economy. Oil is consumed across the transportation and industrial sectors, accounting for a large share of the global energy mix. Exploration and production (E&P) activity is a major employer and accounts for a large percentage of GDP in oil-producing nations. Oil and gas drilling accounts for around 4 per cent of total global GDP.
When prices for crude oil are high, costs for energy-intensive businesses such as manufacturers and airlines rise, while producers benefit from increased revenues and exporting nations increase their budgets. Conversely, lower oil prices reduce costs for users but also reduce income and investment for producing nations.
What drives crude oil prices?
Oil prices and the economy are inextricably linked. Global GDP growth lifts oil demand as industrial production expands, and higher demand, in turn, lifts prices. With the International Monetary Fund projecting a 4.9 per cent decline in global GDP in 2020 because of the impact of the Covid-19 pandemic in halting economic activity, oil demand is also set to be lower this year. The International Energy Agency (IEA) expects that global oil demand will be a record 9.3 million barrels per day lower in 2020 than it was in 2019, as lockdowns to slow the spread of the pandemic have hit road transportation, aviation and manufacturing.
That fall in demand contributed to the plunge in crude oil prices from the start of the year to the negative turn in April.
Supply is also a major price driver. Oil prices were already falling before the pandemic hit, as two of the world’s largest producers – Saudi Arabia and Russia – engaged in a price war to secure market share. The members of the Organization of the Petroleum Exporting Countries (OPEC) and other major producers have since agreed several times to cut production in an attempt to support prices.
A shift in the global supply dynamic has fundamentally changed the pricing on the oil market. Over the years, the global benchmark Brent crude oil market has established a widening premium to the US benchmark West Texas Intermediate (WTI) market, even though WTI crude is lighter and sweeter than Brent, which describes its low density and low sulphur content. North Sea oil fields – from which Brent crude is extracted – have become depleted while North American production from shale formations and oil sands has expanded rapidly, exacerbating oversupply in the US market.
Weather is another key driver on the supply side, as conditions can disrupt production and drive up prices, such as when Hurricane Katrina reduced US output in 2005 and pushed up prices to record highs.
The amount of oil held in storage can also affect prices, as it indicates the availability of supply on the market; storage fills up when the market is oversupplied and is drawn down when supply is tight.
Impact of low oil prices on the economy: who are the losers?
The recent volatility in the oil market has raised questions about the effect of low oil prices on the economy.
Falling oil prices would typically benefit consumers and businesses if they result in lower gasoline prices that increase disposable income and lower jet fuel prices that cut airline ticket prices. But during the Covid-19 lockdowns and their aftermath, road transport has plummeted by 50-75 per cent, negating the benefit of lower prices at the pump as people have stayed home. Airlines have been grounded, cutting demand for jet fuel.
The US became the world’s largest oil producer in 2018, as the shale revolution boosted output beyond production from Russia and Saudi Arabia. That has shifted its perspective on oil prices. While lower prices were seen as beneficial for US transportation and industry, the growth of the domestic oil and gas sector favours higher prices to support investment and employment not just in exploration and production, but related downstream industries. The oil and gas industry accounts for around 8 per cent of US GDP, according to the American Petroleum Institute (API).
The lower oil price has reduced US oil production by almost 2.5 million barrels per day from previous expectations, according to Rystad Energy. At an average WTI price of $30 per barrel in 2020, about 73 E&P companies in the US may have to file for Chapter 11 bankruptcy protection this year, with 170 more following in 2021, according to the research firm. There could be more bankruptcies in lower price scenarios. More than 100,000 oil and gas jobs have been lost in the US, and wages could fall by at least 8-10 per cent in 2021. That will have a knock-on effect through the US economy, with the rise in unemployment reducing consumer spending.
Global E&P investments are expected to fall by around 30 per cent this year. Low oil prices have a significant geopolitical impact on nations that depend on revenue from oil production. Countries such as Venezuela and Nigeria face increased instability from lower oil revenues, and the likes of Saudi Arabia and Russia rely on oil to fund their state budgets. Norway has seen lower oil prices hit its sovereign wealth fund at a time when it has had to draw on the fund to provide economic stimulus.
However, at the same time, oil-importing countries benefit from lower prices, and developing countries are more often dependent on oil for fuel rather than alternative sources.
Overall, the impact of low oil prices on the economy is likely to remain a concern as countries emerge from lockdowns and attempt to jumpstart their economic recovery.
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