Falling oil prices: A blessing or a curse?

The story is told of the old wise woman in the village and the naughty young boy who was intent on embarrassing her. The young lad decided he would ask her a trick question that would fulfil his devious scheme. With a live butterfly in his palm, he would approach the woman to ask her if it was alive or dead. If she answered in the affirmative he would crash it. If she said it was dead, he would let it fly. On the material day, she approached the lady in a public platform and posed his question. “It all depends on you” was her only reply, leaving the boy dejected at his failed mission. 

Economists globally are faced with the same dilemma as the old wise woman in the story. This has to do with oil prices as the world waits in baited breath to get their perspective of whether the tumble is a positive or negative to the global economy. 

On June 30, 2008, a spike in what was then soaring global economy saw the prices of Brent Crude, an international benchmark, reach an unprecedented peak of $138 a barrel. What followed was a quick plummet as dramatic as the rise. In a quick twist of events, barely six months later, Dec 2008, the prices had come down to the lows of $40 a barrel and the world economy was in a spin off. The last time prices had touched that low had been in December 2004. We were officially in recession with fears of a greater depression hanging in the air. 

Luckily, our fears were unrealised and the world economy started recovering and, with it, oil prices. They reached a peak of $115 in June this year. But then, all of a sudden, the global oil prices have started tumbling to lows of $85 in October 2014 with indications showing that they may tumble even further. Despite an obvious win for oil consumers, given the previous correlation about the recession and the falling oil prices, you can understand why this downward trend is not being received as all good news in all quarters. 

Economics 101.Price of goods is determined by the twin factors of supply and demand. Rising supply has a downward push on the price. Rising demand has an upward push on the price. Ditto the price of oil. As the Economist recently pointed out, the big economic question is whether lower prices reflect weak demand or have been caused by a surge in the supply of crude. 

If weak demand is the culprit, it is worrying: it suggests the oil price is a symptom of weakening growth. If the source of weakness is financial (debt overhangs and so on), then cheaper oil may not boost growth all that much: consumers may simply use the gains to pay down their debts. 

Indeed, in some countries, cheaper oil may even make matters worse by increasing the risk of deflation. On the other hand, if plentiful supply is driving prices down, that is potentially better news: cheaper oil should eventually boost spending in the world’s biggest economies. As easy as pie as it seems, it is massively difficult to pinpoint exactly what is causing the price tumble. The global economy is such a complex web that it is only practically possible to work with it as an approximated rather than exact science. 

The easier side to show would be the supply side. Since April last year the world’s total output of oil has been rising strongly. Most months’ output has been one to two million barrels a day (b/d) higher than the year before. In September, global output was 2.8m b/d above the level of September 2013. Whether by design (US influence to frustrate Russia and Iran) we don’t know. 

Still in the Economist, the global economy is certainly weak. Japan’s GDP fell in the second quarter. Germany’s did too, and may be heading towards recession (recent figures for industrial production and exports were dreadful). America’s growth has accelerated recently, but its recovery is weak by historical standards. 

Weaker growth translates to lower energy demand. The International Energy Agency, an oil importers’ club, in October said it expects global demand to rise by just 700,000 barrels a day (b/d) this year. That is 200,000 b/d below its forecast the previous month. Demand has been weak for a while but the recent slowdown —notably in Germany — took markets by surprise, hence the sharp fall in the price.

 

So to answer the world, just like the old woman, whether the tumbling oil prices is good or bad for the global economy depends from which perspective you look at. Bigger question is, what about from a Kenyan perspective? That is a trajectory for another article.

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