As we saw in Part 1 of this blog, oil prices have fallen by some 46% in the past five months. In that blog we looked at the implications for fuel prices. Here we look at the broader implications for the global economy? Is it good or bad news – or both?
First we’ll look at the oil-importing countries. To some extent the lower oil price is a reflection of weak global demand as many countries still struggle to recover from recession. If the lower price boosts demand, this may then cause the oil price to rise again. At first sight, this might seem merely to return the world economy to the position before the oil price started falling: a leftward shift in the demand for oil curve, followed by a rightward shift back to where it was. However, the boost to demand in the short term may act as a ‘pump primer’. 
The higher aggregate demand may result in a multiplier effect and cause a sustained increase in output, especially if it stimulates a rise in investment through rising confidence and the accelerator, and thereby increases capacity and hence potential GDP.
But the fall in the oil price is only partly the result of weak demand. It is mainly the result of increased supply as new sources of oil come on stream, and especially shale oil from the USA. Given that OPEC has stated that it will not cut its production, even if the crude price falls to $40 per barrel, the effect has been a shift in the oil supply curve to the right that will remain for some time.
So even if the leftward shift in demand is soon reversed so that there is then some rise in oil prices again, it is unlikely that prices will rise back to where they were. Perhaps, as the diagram illustrates, the price will rise to around $70 per barrel. It could be higher if world demand grows very rapidly, or if some sources of supply go off stream because at such prices they are unprofitable.
The effect on oil exporting countries has been negative. The most extreme case is Russia, where for each $10 fall in the price of oil, its growth rate falls by around 1.4 percentage points (see). Although the overall effect on global growth is still likely to be positive, the lower oil price could lead to a significant cut in investment in new oil wells. North sea producers are predicting a substantial cut in investment. Even shale oil producers in the USA, where the marginal cost of extracting oil from existing sources is only around $10 to £20 per barrel, need a price of around $70 or more to make investment in new sources profitable. What is more, typical shale wells have a life of only two or three years and so lack of investment would relatively quickly lead to shale oil production drying up.
The implication of this is that although there has been a rightward shift in the short-run supply curve, if price remains low the curve could shift back again, meaning that the long-run supply curve is much more elastic. This could push prices back up towards $100 if global demand continues to expand.
This can be illustrated in the diagram. The starting point is mid-2014. Global demand and supply are D1 and S1; price is $112 per barrel and output is Q1. Demand now shifts to the left and supply to the right to D2 and S2 respectively. Price falls to $60 per barrel and, given the bigger shift in supply than demand, output rises to Q2. At $60 per barrel, however, output of Q2 cannot be sustained. Thus at $60, long-run supply (shown by SL) is only Q4.
But assuming the global economy grows over the coming months, demand shifts to the right: say, to D3. Assume that it pushes price up to $100 per barrel. This gives a short-run output of Q3, but at that price it is likely that supply will be sustainable in the long run as it makes investment sufficiently profitable. Thus curve D3 intersects with both S2 and SL at this price and quantity.
The articles below look at the gainers and losers and at the longer-term effects.
Articles
Where will the oil price settle? BBC News, Robert Peston (22/12/14)
Falling oil prices: Who are the winners and losers? BBC News, Tim Bowler (16/12/14)
Why the oil price is falling The Economist (8/12/14)
The new economics of oil: Sheikhs v shale The Economist (6/12/14)
Shale oil: In a bind The Economist (6/12/14)
Falling Oil Price slows US Fracking Oil-price.net, Steve Austin (8/12/14)
Oil Price Drop Highlights Need for Diversity in Gulf Economies IMF Survey (23/12/14)
Lower oil prices boosting global economy: IMF Argus Media (23/12/14)
Collapse in oil prices: producers howl, consumers cheer, economists fret The Guardian (16/12/14)
North Sea oilfields ‘near collapse’ after price nosedive The Telegraph, Andrew Critchlow (18/12/14)
How oil price fall will affect crude exporters – and the rest of us The Observer, Phillip Inman (21/12/14)
Cheaper oil could damage renewable energies, says Richard Branson The Guardian,
Richard Branson: ‘Governments are going to have to think hard how to adapt to low oil prices.’ John Vidal (16/12/14)
Data
Brent crude prices U.S. Energy Information Administration (select daily, weekly, monthly or annual data and then download to Excel)
Brent Oil Historical Data Investing.com (select daily, weekly, or monthly data and time period)
Questions
- What would determine the size of the global multiplier effect from the cut in oil prices?
- Where is the oil price likely to settle in (a) six months’ time; (b) two years’ time? What factors are you taking into account in deciding your answer?
- Why, if the average cost of producing oil from a given well is $70, might it still be worth pumping oil and selling it at a price of $30?
- How does speculation affect oil prices?
- Why has OPEC decided not to cut oil production even though this is likely to drive the price lower?
- With Brent crude at around $60 per barrel, what should North Sea oil producers do?
- If falling oil prices lead some oil-importing countries into deflation, what will be the likely macroeconomic impacts?
Oil prices have been plummeting in recent months. Indeed, many commentators are saying that this is the major economics news story of 2014. In June 2014 Brent crude was around $112 per barrel. By December the price has fallen to around $60 – a fall of 46%. But what are the implications for fuel prices?
Just because the crude oil price has fallen by 46%, this does not mean that prices at the pump should do the same. Oil is priced in dollars and the pound has depreciated against the dollar by just over 7% since June, from around £1 = $1.69 to around £1 = $1.57. Thus in sterling terms, crude oil has fallen by only 42%.
More significantly, the cost of crude is a relatively small percentage of the price of a litre of petrol. At a price of 132p per litre (the July average price), crude accounted for around 27% of the price, or around 36p per litre. At a price of 114p per litre, the price in late December, crude accounts for around 19% of the price, or around 21.5p per litre. The largest element of price is fuel duty, which is charged at a flat rate of 57.95p per litre. In addition there is VAT at 20% of the pre-VAT price (or 16.67% of the retail price). Finally there are the refining, distribution and retail costs and margins, but these together account for only around 16p per litre.
What this means is that the 46% cut in oil prices has led to a cut in petrol prices of only around 14%. If petrol prices were to reach £1 per litre, as some commentators have forecast, crude oil prices would have to fall to under $40 per barrel.
Although petrol and diesel prices have fallen by a smaller percentage than oil prices, this still represents a significant cut in motoring and transport costs. It also represents a significant cut in costs for the petrochemical industry and other industries using large amounts of oil.
For oil-importing countries this is good news as the fall in the oil price represents an increase in real incomes. For oil importing countries, and especially those such as Russia and some OPEC countries where oil constitutes a large proportion of their exports, it is bad news. We explore these effects in Part 2.
Videos
UK petrol prices hit four-year low BBC News, John Moyland (10/12/14)
Petrol prices plunge ahead of Christmas holidays Belfast Telegraph (19/12/14)
Petrol price plummet – could fuel drop to below a pound a litre in the New Year? Channel 5 News on YouTube (17/12/14)
Articles
UK motorists benefit from petrol price drop Financial Times, Michael Kavanagh (23/12/14)
Petrol to drop to £1 a litre, says Goldman Sachs The Telegraph, Szu Ping Chan (9/12/14)
Oil prices: How low will they go in 2015? International Business Times, Shane Croucher (22/12/14)
Plummeting oil price may lead to petrol falling below £1 a litre RAC news (17/12/14)
Pump Prices: Cheap Petrol Comes With A Warning Sky News (19/12/14)
Data and information
Fuel prices in Europe Drive Alive (20/12/14)
Weekly road fuel prices Department of Energy & Climate Change (23/12/14)
Prices at the pump – why are they falling and will this continue? ONS (18/12/14)
Fuel Prices Explained RAC
UKPIA Statistical Review 2014 United Kingdom Petroleum Industry Association
Questions
- Why does the price of petrol fluctuate less in percentage terms than the price of crude oil?
- What factors will affect whether UK petrol prices fall to £1 per litre?
- If crude oil prices fell by 20%, in which of these two cases would there be a bigger percentage fall in petrol prices: (a) petrol price currently 140p; (b) petrol price currently 110p? Explain.
- Distinguish between a specific tax and an ad valorem tax. Which of these is (a) fuel duty; (b) VAT? Illustrate your answer with a supply and demand diagram.
- What determines the price elasticity of demand for petrol and diesel? Is the long-run elasticity likely to be higher or lower than the short-run elasticity? Explain.
- Distinguish between demand-pull and cost-push inflation. Given that oil price changes are correlated to inflation, would you characterise recent falls in inflation as reductions in demand-pull or cost-push pressures, or both: (a) in a specific oil-importing country; (b) globally?
As we reported in New Build: Foundations for a successful housing policy? the Autumn Statement heralded significant reforms to Stamp Duty – the UK tax on house purchases. The result is the introduction of a graduated system of tax, along the lines of the income tax system. A similar regime will continue to operate in Scotland when the Land and Buildings Transactions Tax replaces Stamp Duty next April. Here we consider the impact on the effective rates of tax following the changes to Stamp Duty.
Under the old system any house purchase involving a property whose value was £125,000 or less incurred no Stamp Duty liability. Thereafter, one of five tax rates applied: 1% above £125,000 to £250,000, 3% above £250,000 to £500,000, 4% above £500,000 to £1m, 5% above £1m to £2m and 7 per cent for properties over £2m. The important point was that the whole of the purchase price was subject to one of these five progressively higher tax rates.
The new system sees the introduction of a graduated system of tax which means that the amount paid by house purchasers will be dependent upon the proportion of the value of the property that falls in each of the tax bands. Again, for properties up to £125,000 there will be no liability. There will then be four bands: 1% above £125,000 to £250,000, 5% above £250,000 up to £925,000, 10% above £925,000 up to £150,000 and 12% above £150,000.
One significant impact of the changes is that the liability will be more proportionate to the value of the property. To see this we can compare the average rate of tax under the new and old tax system. The average rate of tax is simply the amount of the tax liability relative to the price of the property.
From Chart 1 we can see how the new average rate of tax under rises progressively with the price of the property. (Click here to download a PowerPoint of the chart). Under the old system, the profile of the average rate of tax looks like a series of steps with a slab at each tax rate. Unsurprisingly, the system was sometimes referred as the ‘slab system’.
A second significant change will be the removal of the significant spikes in the marginal rate of tax around each of the tax bands. For example, the tax liability on a property costing £125,001 was £1,250.01 compared with a zero liability on a property costing £125,000. Therefore, a £1 rise in the price of property was accompanied by a £1,250.01 rise in the purchase tax. In percentage terms this is a marginal rate of tax of 125,001. Chart 1 shows how the marginal rates now match the progressively higher tax rates that become payable between each threshold.
The principle of removing the significant distortions to pricing created by the old system of Stamp Duty is likely to receive general approval. However, there may be some unease around the short-term implications for house prices of the bands and rates under the new system. This is largely because nobody purchasing a property at £937,000 or less will see their tax liability rise. The reduction in the liability raises concerns about a potential boost to house prices.
Chart 2 show the percentage change in the Stamp Duty liability for properties of up to £2.5 million. (Click here to download a PowerPoint of the chart.) The average UK house price, excluding London, is currently £235,000. The stamp duty saving in this case is £150 or 6.4 per cent.
But there are more significant savings than this from the reforms, including in London where inflationary pressures in the housing market have been more significant. Here annual price inflation ran at close to 20 per cent in the second and third quarters of the year. Given that the average house price in London is currently £510,000, this means a Stamp Duty saving of £4,900 or 24 per cent. Of course, for premium London markets (and other similar markets elsewhere) a quite different effect could arise. The liability on a £2m property rises by 53.75 per cent. Nonetheless, for most markets it is the boost to prices that is most concerning.
In the East Midlands, which is a good barometer of the market in the rest of the country, there will be a saving of £610 or 32 per cent on the current average property purchase of £189,000. Therefore, even in markets where house price inflation is more subdued there is the potential that the changes to the Stamp Duty system will, in the short term at least, boost housing demand and fuel house price growth.
Stamp Duty/Land and Buildings Transactions Tax
Rates and allowances: Stamp Duty Land Tax Gov.UKLand and Buildings Transaction Tax Revenue Scotland
Autumn Statement
Autumn Statement: documents Gov.UK
Articles
The home owners cashing in on stamp duty reforms Telegraph, Dan Hyde (2/12/14)
Christmas comes early for estate agents after stamp duty changes Guardian, Nigel Bunyan (7/12/14)
Stamp duty: House price boom and mansion bust Telegraph, Anna White (6/12/14)
£200m house deal stampede by wealthy to beat stamp duty hike: Reforms spark one of busiest periods for estate agents in 25 years Daily Mail Online, Louise Eccles and Ruth Lythe (5/12/14)
Stamp duty changes boost housing market and push up prices Guardian, Hilary Osborne (5/12/14)
Stamp Duty revamp blow to SNP property tax reforms Scotsman, Tom Peterkin and Jane Bradley (4/12/14)
Autumn Statement: What do stamp duty changes mean? BBC News, (3/12/14)
Data
House Price Indices: Data Tables Office for National Statistics
Questions
- What is the tax base of Stamp Duty and the Land and Buildings Transaction Tax?
- How does Stamp Duty distort choices?
- Under the old Stamp Duty system, why might a seller be reluctant to put their property on the market at £251,000?
- What is meant by the average and marginal rates of tax?
- What is meant by a progressive tax?
- What is the connection between the average rate of tax and how progressive a tax is?
- Calculate the marginal rates of tax (in percentage terms) under the old Stamp Duty system following a £1 rise which results in a property’s value moving into the next tax band (start with a £1 rise from £125,000 to £125,001).
- Using a demand-supply diagram show the effect of the Stamp Duty reforms on house prices in most UK housing markets. What characteristics of supply would make the change in price particularly large?
- Are there any housing markets where demand could fall following the introduction of the reforms to Stamp Duty? Illustrate the possible effects using a demand-supply diagram.
- How might an economist go about evaluating the Stamp Duty reforms? What factors will affect the judgement formed?
The housing market was at the heart of the 2014 Autumn Statement. Perhaps most eyecatching were the reforms to stamp duty. Stamp Duty is a tax on house purchases. Overnight we have seen the introduction of a graduated system of tax, along the lines of the income tax system – similar to the model to be adopted in Scotland from next April under the Land and Buildings Transactions Tax. For the rest of the UK, there will be five tax bands, including a zero rate band for property values up to £125,000. The total tax liability will be dependent upon the proportion of the value of the property that falls in each taxable band.
But, alongside the Stamp Duty announcement, the Autumn Statement was noteworthy for its references to new build. New build is clearly central to UK housing policy.
The Autumn Statement reaffirmed the government’s wish to see house building play a central role in easing pressures on the housing market. Over the past 40 years or more UK house prices have been characterised by considerable volatility and by a significant real increase. This can be seen clearly in the chart. 
Actual (nominal) house prices across the UK have grown an average rate of 10 per cent per year. Even if we strip out the effect of economy-wide inflation, we are still left with an increase of around 3.5 per cent per year. (Click here to download a PowerPoint of the chart).
The economics point to supply-side problems that mean demand pressures feed directly into house prices. The commitment to build has now seen the announcement of a new garden city near Bicester in Oxfordshire. This is set to provide 13,000 or more new homes. The government has also pledged £100 million to the Ebbsfleet Garden City project to provide the infrastructure and land remediation necessary to bring in more private-sector developers to help deliver an expected 15,000 new homes.
An interesting development in housing policy is the willingness of government to consider being more actively involved itself in house building. The development of former barracks at Northstowe in Cambridgeshire will be spearheaded by the Homes and Communities Agency which will lead on the planning and construction of up to 10,000 new homes. This signals, at least on paper, that government is prepared to think more broadly about the way in which it works with the private sector in helping to deliver new homes.
The desire to facilitate new build appears to make some economic sense. But, the politics of delivering on new homes is considerably more difficult since the prospect of new developments naturally raises considerable local concerns. Furthermore, it does not deal with fundamental questions around the existing housing market stock. In particular, how we can further increase investment in our existing housing stock, especially given the significant land constraints that face a country like the UK. As yet, the debate around how to improve what we already have has not really taken place.
Autumn Statement
Autumn Statement: documents Gov.UK
Articles
Autumn Statement: Government will build tens of thousands of new homes Independent, Nigel Morris (2/12/14)
Government could build and sell new homes on public sector land Guardian, Patrick Wintour (2/12/14)
Bicester chosen as new garden city with 13,000 homes BBC News, (2/12/14)
Nick Clegg reveals coalition plan for new garden city in Oxfordshire Guardian, (2/12/14)
State to build new homes for first time in generation Telegraph, Steven Swinford (2/12/14)
Data
House Price Indices: Data Tables Office for National Statistics
Questions
- Explain the distinction between real and nominal house prices.
- Would you expect real house price inflation to always be less than nominal house price inflation?
- What factors are likely to affect housing demand?
- What factors are likely to affect housing supply?
- Show using a demand-supply diagram the impact of rising incomes on the demand for a particular housing market characterised by a price inelastic supply.
- Would we expect all housing markets to exhibit similar characteristics of housing demand and supply?
- What is the economic rationale for the government’s new build policy?
- What other measures could be introduced to try and alleviate the long-term pressure on real house prices?
- How might we go about assessing the affordability of housing?
- Would a policy which reduced for the stamp duty payment of most buyers help to curb inflationary pressures in the housing market? Explain your answer using a demand-supply diagram.
Over the past three months oil prices have been falling. From the beginning of September to the end of November Brent Crude has fallen by 30.8%: from $101.2 to a four-year low of $70.0 per barrel (see chart below: click here for a PowerPoint). The fall in price has been the result of changes in demand and supply.
As the eurozone, Japan, South America and other parts of the world have struggled to recover, so the demand for oil has been depressed. But supply has continued to expand as the USA and Canada have increased shale oil production through fracking. 
As far as OPEC is concerned, rather than cutting production, it decided at a meeting on 27 November to maintain the current target of 30 million barrels a day.
The videos and articles linked below look at these demand and supply factors and what is likely to happen to oil prices over the coming months.
They also look at the winners and losers. Although falling prices are likely in general to benefit oil importing countries and harm oil exporting ones, it is not as simple as that. The lower prices could help boost recovery and that could help to halt the oil price fall and be of benefit to the oil exporting countries. But if prices stay low for long enough, this could lower inflation and even cause deflation (in the sense of falling prices) in many countries. This, in turn, could dampen demand (see the blog post, Deflation danger). This is a particular problem in Japan and the eurozone.
Major oil importing developing countries, such as China and India, however, should see a boost to growth from the lower oil prices.
Some oil exporting countries will be harder hit than others. Russia, in particular, has been badly affected, especially as it is also suffering from the economic sanctions imposed by Western governments in response to the situation in Ukraine. The rouble has fallen by some 32% this year against the US dollar and nearly 23% in the past three months alone.
Then there are the environmental effects. Cheaper oil puts less pressure on companies and governments to invest in renewable sources of energy. And then there are the direct effects on the environment of fracking itself – something increasingly being debated in the UK as well as in the USA and Canada.
Videos
Oil price at four-year low as Opec meets BBC News, Mark Lobel (27/11/14)
Opec losing control of oil prices due to US fracking BBC News, Nigel Cassidy (4/12/13)
How the price of oil is set – video explainer The Telegraph, Oliver Duggan (28/11/14)
How Oil’s Price Plunge Impacts Wall Street Bloomberg TV, Richard Mallinson (28/11/14)
Oil Prices Plummet: The Impact on Russia’s Economy Bloomberg TV, Martin Lindstrom (28/11/14)
Articles
Oil prices plunge after Opec meeting BBC News (28/11/14)
Crude oil prices extend losses Financial Times, Dave Shellock (28/11/14)
Oil price plunges after Opec split keeps output steady The Guardian, Terry Macalister and Graeme Wearden (27/11/14)
Falling oil prices: Who are the winners and losers? BBC News, Tim Bowler (17/10/14)Hooray for cheap oil BBC News, Robert Peston (1/12/14)
Russian Recession Risk at Record as Oil Price Saps Economy Bloomberg, Andre Tartar and Anna Andrianova (28/11/14)
Rouble falls as oil price hits five-year low BBC News (1/12/14)
Data
Brent Spot Price US Energy Information Administration (select daily, weekly, monthly or annual: can be downloaded to Excel)
Spot exchange rate of Russian rouble against the dollar Bank of England
Questions
- Use a diagram to illustrate the effects of changes in the demand and supply of oil on oil prices.
- How does the price elasticity of demand and supply of oil affect the magnitude of these price changes?
- Explain whether (a) the demand for and (b) the supply of oil are likely to be relatively elastic or relatively inelastic? How are these elasticities likely to change over time?
- Distinguish between the spot price and forward prices of oil? If the three-month forward price is below the spot price, what are the implications of this?
- Analyse who gains and who loses from the recent price falls.
- What are the effects of a falling rouble on the Russian economy?
- What are likely to be the effects of further falls in oil prices on the eurozone economy?
As we saw in Part 1 of this blog, oil prices have fallen by some 46% in the past five months. In that blog we looked at the implications for fuel prices. Here we look at the broader implications for the global economy? Is it good or bad news – or both?
