People are beginning to get used to low oil prices and acting as if they are going to remain low. Oil is trading at only a little over $30 per barrel and Saudi Arabia is unwilling to backtrack on its policy of maintaining its level of production and not seeking to prevent oil prices from falling. Currently, there is still a position of over supply and hence in the short term the price could continue falling – perhaps to $20 per barrel.
But what of the future? What will happen in the medium term (6 to 12 months) and the longer term? Investment in new oil wells, both conventional and shale oil, have declined substantially. The position of over supply could rapidly come to an end. The Telegraph article below quotes the International Energy Agency’s executive director, Fatih Birol, as saying:
“Investment in oil exploration and production across the world has been cut to the bone, falling 24% last year and an estimated 17% this year. This is… far below the minimum levels needed to keep up with future demand. …
It is easy for consumers to be lulled into complacency by ample stocks and low prices today, but they should heed the writing on the wall: the historic investment cuts raise the odds of unpleasant oil security surprises in the not too distant future.”
And in the Overview of the IEA’s 2016 Medium-Term Oil Market Report, it is stated that
In today’s oil market there is hardly any spare production capacity other than in Saudi Arabia and Iran and significant investment is required just to maintain existing production before we move on to provide the new capacity needed to meet rising oil demand. The risk of a sharp oil price rise towards the later part of our forecast arising from insufficient investment is as potentially de-stabilising as the sharp oil price fall has proved to be.
The higher-cost conventional producers, such as Venezuela, Nigeria, Angola, Russia and off-shore producers, could take a long time to rebuild capacity as investment in conventional wells is costly, especially off-shore.
As far as shale oil producers is concerned – the prime target of Saudi Arabia’s policy of not cutting back supply – production could well bounce back after a relatively short time as wells are re-opened and investment in new wells is resumed.
But, price rises in the medium term could then be followed by lower prices again a year or two thereafter as oil from new investment comes on stream: or they could continue rising if investment is insufficient. It depends on the overall balance of demand and supply. The table shows the IEA’s forecast of production and consumption and the effect on oil stocks. From 2018, it is predicting that consumption will exceed production and that, therefore, stocks will fall – and at an accelerating rate.
But just what happens to the balance of production and consumption will also depend on expectations. If shale oil investors believe that an oil price bounce is temporary, they are likely to hold off investing. But this will, in turn, help to sustain a price bounce, which in turn, could help to encourage investment. So expectations of investors will depend on what other investors expect to happen – a very difficult outcome to predict. It’s a form of Keynesian beauty contest (see the blog post A stock market beauty contest of the machines) where what is important is what other people think will happen, which in turn depends on what they think other people will do, and so on.
Webcast
At $30 oil price, shale rebound may take much, much longer CNBC, Patti Domm , Bob Iaccino, Helima Croft and Matt Smith (25/2/16)
Article
Opec has failed to stop US shale revolution admits energy watchdog The Telegraph, Ambrose Evans-Pritchard (27/2/16)
Report
Medium-term Oil Market Report 2016: Overview International Energy Agency (IEA) (22/2/16)
Questions
- Using demand and supply diagrams, demonstrate (a) what happened to oil prices in 2015; (b) what is likely to happen to them in 2016; (c) what is likely to happen to them in 2017/18.
- Why have oil prices fallen so much over the past 12 months?
- Using aggregate demand and supply analysis, demonstrate the effect of lower oil prices on a national economy.
- What have have been the advantages and disadvantages of lower oil prices? In your answer, distinguish between the effects on different people, countries and the world generally.
- Why is oil supply more price elastic in the long run than in the short run?
- Why does supply elasticity vary between different types of oil fields (a) in the short run; (b) in the long run?
- What determines whether speculation about future oil prices is likely to be stabilising or destabilising?
- What role has OPEC played in determining the oil price over the past few months? What role can it play over the coming years?
- Explain the concept of a ‘Keynesian beauty contest’ in the context of speculation about future oil prices, and why this makes the prediction of future oil prices more difficult.
- Give some other examples of human behaviour which is in the form of a Keynesian beauty contest.
- Why may playing a Keynesian beauty contest lead to an undesirable Nash equilibrium?
There is a select group of countries (areas) that have something in common: the USA, the UK, Japan and the eurozone. The currency in each of these places is one of the IMF’s reserve currencies. But is China about to enter the mix?
The growth of China has been spectacular and it is now the second largest economy in the world, behind the USA. It is on the back on this growth that China has asked the IMF for the yuan to be included in the IMF’s basket of reserve currencies. The expectation is that Christine Lagarde, the IMF’s Managing Director, will announce its inclusion and, while some suggest that the yuan could become one of the major currencies in the world over the next decade following this move, others say that this is just a ‘symbolic gesture’. But that doesn’t seem to matter, according to Andrew Malcolm, Asia head of capital at Linklaters:
“The direct impact won’t be felt in the near term, not least because implementation of the new basket won’t be until Q3 2016. However the symbolic importance cannot be overlooked…By effectively endorsing the renminbi as a freely useable currency, it sends a strong signal about China’s importance in the global financial markets.”
Concerns about the yuan being included have previously focused on China’s alleged under-valuation of its currency, as a means of boosting export demand, as we discussed in What a devalued yuan means to the rest of the world. However, China has made concerted efforts for the IMF to make this move and China’s continuing financial reforms may be essential. The hope is that with the yuan on the IMF’s special list, it will boost the use of the yuan as a reserve currency for investors. It will also be a contributor to the value of the special drawing right, which is used by the IMF for pricing its emergency loans.
Although the Chinese stock market has been somewhat volatile over the summer period, leading to a devaluation of the currency, it is perhaps this move towards a more market based exchange rate that has allowed the IMF to consider this move. We wait for an announcement from the IMF and the articles below consider this story.
Chinese yuan likely to be added to IMF special basket of currencies The Guardian, Katie Allen (29/11/15)
‘Chinese yuan set for IMF reserve status BBC News (30/11/15)
IMF to make Chinese yuan reserve currency in historic move The Telegraph, James Titcomb (29/11/15)
China selloff pressure Asia stocks, yuan jumpy before IMF decision Reuters, Hideyuki Sano (30/11/15)
IMF’s yuan inclusion signals less risk taking in China Reuters, Pete Sweeney and Krista Hughes (29/11/15)
Did the yuan really pass the IMF currency test? You’ll know soon Bloomberg, Andrew Mayeda (29/11/15)
Questions
- What is meant by a reserve currency?
- Why do you think that the inclusion of the yuan on the IMF’s list of reserve currencies will boost investment in China?
- One of the reasons for the delay in the yuan’s inclusion is the alleged under-valuation of the currency. How have the Chinese authorities allegedly engineered a devaluation of the yuan? To what extent could it be described as a ‘depreciation’ rather than a ‘devaluation’?
- Look at the key tests that the yuan must pass in order to be included. Do you think it has passed them given the report produced a few months ago?
- The weighting that a currency is given in the IMF’s basket of currencies affects the interest rate paid when countries borrow from the IMF. How does this work?
The demand for oil is growing and yet the price of oil, at around $46 per barrel over the past few weeks, remains at less than half that of the period from 2011 to mid 2014. The reason is that supply has been much larger than demand. The result has been a large production surplus and a growth in oil stocks. Supply did fall somewhat in October, which reduced the surplus in 2015 Q3 below than of the record level in Q2 – but the surplus was still the second highest on record.
What is more, the modest growth in demand is forecast to slow in 2016. Supply, however, is expected to decrease through the first three quarters of 2016, before rising again at the end of 2016. The result will be a modest rise in price into 2016, to around $56 per barrel, compared with an average of just over $54 per barrel so far for 2015 (click here for a PowerPoint of the chart below).
But why does supply remain so high, given such low prices? As we saw in the post The oil industry and low oil prices, it is partly the result of increases in supply from large-scale investment in new sources of oil over the past few years, such as the fracking of shale deposits, and partly the increased output by OPEC designed to keep prices low and make new investment in shale oil unprofitable.
So why then doesn’t supply drop off rapidly? As we saw in the post, A crude indicator of the economy (Part 2), even though shale oil producers in the USA need a price of around $70 or more to make investment in new sources profitable, the marginal cost of extracting oil from existing sources is only around $10 to £20 per barrel. 
This means that shale oil production will continue until the end of the life of the wells. Given that wells typically have a life of at least three years, it could take some time for the low prices to have a significant effect on supply. According to the US Energy Information Administration’s forecasts, US crude oil production will drop next year by only just over 5%, from an average of 9.3 million barrels per day in 2015 to 8.8 million barrels per day in 2016.
In the meantime, we can expect low oil prices to continue for some time. Whilst this is bad news for oil exporters, it is good news for oil importing countries, as the lower costs will help aid recovery.
Webcasts
IEA says oil glut could worsen through 2016 Euronews (13/11/15)
IEA Says Record 3 Billion-Barrel Oil Stocks May Deepen Rout BloombergBusiness, Grant Smith (13/11/15)
Articles
IEA Offers No Hope For An Oil-Price Recovery Forbes, Art Berman (13/11/15)
Oil glut to swamp demand until 2020 Financial Times, Anjli Raval (10/11/15)
Record oil glut stands at 3bn barrels BBC News (13/11/15)
Global oil glut highest in a decade as inventories soar The Telegraph, Mehreen Khan (12/11/15)
The Oil Glut Was Created In Q1 2015; Q3 OECD Inventory Movements Are Actually Quite Normal Seeking Alpha (13/11/15)
Record oil glut stands at 3 billion barrels Arab News (14/11/15)
OPEC Update 2015: No End To Oil Glut, Low Prices, As Members Prepare For Tense Meeting International Business Times, Jess McHugh (12/11/15)
Surviving The Oil Glut Investing.com, Phil Flynn (11/11/15)
Reports and data
Oil Market Report International Energy Agency (IEA) (13/11/15)
Short-term Energy Outlook US Energy Information Administration (EIA) (10/11/15)
Brent Crude Prices US Energy Information Administration (EIA)
Questions
- Using demand and supply diagrams, demonstrate (a) what has been happening to oil prices in 2015 and (b) what is likely to happen to them in 2016.
- How are the price elasticities of demand and supply relevant in explaining the magnitude of oil price movements?
- What are oil prices likely to be in five years’ time?
- Using aggregate demand and supply analysis, demonstrate the effect of lower oil prices on a national economy.
- Why might the downward effect on inflation from lower oil prices act as a stimulus to the economy? Is this consistent with deflation being seen as requiring a stimulus from central banks, such as lower interest rates or quantitative easing?
- Do you agree with the statement that “Saudi Arabia is acting directly against the interests of half the cartel and is running OPEC over a cliff”?
- If the oil price is around $70 per barrel in a couple of years’ time, would it be worth oil companies investing in shale oil wells at that point? Explain why or why not.
- Distinguish between short-run and long-run shut down points. Why is the short-run shut down price likely to be lower than the long-run one?
First the IMF in its World Economic Outlook, then the European Commission in its Economic Forecasts (see also) and now the OECD in its Economic Outlook (see also) – all three organisations in the latest issues of their 6-monthly publications are predicting slower global economic growth than they did 6 months previously. This applies both to the current year and to 2016. The OECD’s forecast for global growth this year is now 2.9%, down from the 3.7% it was forecasting a year ago. Its latest growth forecast for 2016 is 3.3%, down from the 3.9% it was forecasting a year ago.
Various reasons are given for the gloomier outlook. These include: a dramatic slowdown in global trade growth; slowing economic growth in China and fears over structural weaknesses in China; falling commodity prices (linked to slowing demand but also as a result of increased supply); austerity policies as governments attempt to deal with the hangover of debt from the financial crisis of 2007/8; low investment leading to low rates of productivity growth despite technological progress; and general fears about low growth leading to low spending as people become more cautious about their future incomes.
The slowdown in trade growth (forecast to be just 2% in 2015) is perhaps the most worrying for future global growth. As Angel Gurría, OECD Secretary-General, states in his remarks at the launch of the latest OECD Economic Outlook:
‘Global trade, which was already growing slowly over the past few years, appears to have stagnated and even declined since late 2014, with the weakness centering increasingly on emerging markets, particularly China. This is deeply concerning as robust trade and global growth go hand in hand. In 2015 global trade is expected to grow by a disappointing 2%. Over the past five decades there have been only five other years in which trade growth has been 2% or less, all of which coincided with a marked downturn of global growth.’
So what policies should governments pursue to stimulate economic growth? According to Angel Gurría:
‘Short-term demand needs to be supported and structural reforms to be pursued with greater ambition than is currently the case. Three specific actions are key:
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First, we need to resist and turn back rising protectionism. Trade strengthens competition and investment and revs up the “diffusion machine” – the spread of new technologies throughout the economy – which will ultimately lift productivity. |
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Second, we need to step up structural reform efforts, which have weakened in recent years. And here, I mean the whole range of structural reforms – education, innovation, competition, labour and product market regulation, R&D, taxes, etc. |
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Third, there is scope to adjust public spending towards investment. If done collectively by all countries, if the sector and projects chosen have high multipliers, and if combined with serious structural reforms, stronger public investment can give a boost to growth and employment and not increase the relative debt burden.’ |
On this third point, the OECD Economic Outlook argues that ‘the rationale for such investments is that they could help to push economies onto a higher growth path than might otherwise be the case, at a time when private investment growth remains modest.’
‘Collective action to increase public investment can be expected to boost the initial domestic multiplier effects from the stimulus, since private investment and exports in each economy will benefit from stronger demand in other economies. …the multiplier effects from an investment-led stimulus are likely to be a little larger than from other forms of fiscal stimulus, since the former also has small, but positive, supply-side effects.
In other words, the OECD is calling for a relaxation of austerity policies, with public investment being used to provide a stimulus to growth. The higher growth will then lead to increased potential output, as well as actual output, and an increase in tax revenues.
These policy recommendations are very much in line with those of the IMF.
Videos and Webcasts
OECD warns of global trade slowdown, trims growth outlook again Reuters (9/11/15)
OECD returns to revisionism with growth downgrade Euronews, Robert Hackwill (9/11/15)
OECD: Weak China Import Growth Leads Trade Slowdown Bloomberg, Catherine L Mann, OECD Chief Economist (9/11/15)
OECD Economic Outlook: Moving forward in difficult times OECD PowerPoint presentation, Catherine L Mann, OECD Chief Economist (9/11/15)
Press Conference OECD, Angel Gurría and Álvaro Pereira (9/11/15)
Articles
OECD cuts world growth forecast Financial Times, Ferdinando Giugliano (9/11/15)
OECD rings alarm bell over threat of global growth recession thanks to China slowdown Independent, Ben Chu (10/11/15)
OECD cuts global growth forecasts amid ‘deep concern’ over slowdown BBC News (9/11/15)
OECD fears slowdown in global trade amid China woes The Guardian, Katie Allen (9/11/15)
The global economy is slowing down. But is it recession – or protectionism? The Observer, Heather Stewart and Fergus Ryan (14/11/15)
Global growth is struggling, but it is not all bad news The Telegraph, Andrew Sentance (13/11/15)
OECD Publications
Economic Outlook Annex Tables OCED (9/11/15)
Press Release: Emerging market slowdown and drop in trade clouding global outlook OCED (9/11/15)
Data handout for press OECD (9/11/15)
OECD Economic Outlook, Chapter 3: Lifting Investment for Higher Sustainable Growth OCED (9/11/15)
OECD Economic Outlook: Full Report OECD (9/11/15)
Questions
- Is a slowdown in international trade a cause of slower economic growth or simply an indicator of slower economic growth? Examine the causal connections between trade and growth.
- How worried should we be about disappointing growth in the global economy?
- What determines the size of the multiplier effects of an increase in public investment?
- Why are the multiplier effects of an increase in public-sector investment likely to be larger in the USA and Japan than in the UK, the eurozone and Canada?
- How can monetary policy be supportive of fiscal policy to stimulate economic growth?
- Under what circumstances would public-sector investment (a) stimulate and (b) crowd out private-sector investment?
- How would a Keynesian economist respond to the recommendations of the OECD?
- How would a neoclassical/neoliberal economist respond to the recommendations?
- Are the OECD’s recommendations in line with the Japanese government’s ‘three arrows‘?
- What structural reforms are recommended by the OECD? Are these ‘market orientated’ or ‘interventionist’ reforms, or both? Explain.
Interest rates in the UK have been at a record low since 2009, recorded at just 0.5%. In July, the forward guidance from Mark Carney seemed to indicate that a rate rise would be likely towards the start of 2016. However, with the recovery of the British economy slowing, together with continuing problems in Europe and slowdowns in China, a rate rise has become less likely. Forward guidance hasn’t been particularly ‘guiding’, as a rate rise now seems most likely well into 2016 or even in 2017 and this is still very speculative.
Interest rates are a key tool of monetary policy and one of the government’s demand management policies. Low interest rates have remained in the UK as a means of stimulating economic growth, via influencing aggregate demand. Interest rates affect many of the components of aggregate demand, such as consumption – through affecting the incentive to save and spend and by affecting mortgage rates and disposable income. They affect investment by influencing the cost of borrowing and net exports through changing the exchange rate and hence the competitiveness of exports.
Low interest rates therefore help to boost all components of aggregate demand and this then should stimulate economic growth. While they have helped to do their job, circumstances across the global economy have acted in the opposite direction and so their effectiveness has been reduced.
Although the latest news on interest rates may suggest some worrying times for the UK, the information contained in the Bank of England’s Inflation Report isn’t all bad. Despite its predictions that the growth rate of the world economy will slow and inflation will remain weak, the predictions from August remain largely the same. The suggestion that interest rates will remain at 0.5% and that any increases are likely to be at a slow pace will flatten the yield curve, and, with predictions that inflation will remain weak, there will be few concerns that continuing low rates will cause inflationary pressures in the coming months. Mark Carney said:
“The lower path for Bank Rate implied by market yields would provide more than adequate support to domestic demand to bring inflation to target even in the face of global weakness.”
However, there are many critics of keeping interest rates down, both in the UK and the USA, in particular because of the implications for asset prices, in particular the housing market and for the growth in borrowing and hence credit debt. The Institute of Directors Chief Economist, James Sproute said:
“There is genuine apprehension over asset prices, the misallocation of capital and consumer debt…Borrowing is comfortably below the unsustainable pre-crisis levels, but with debt once against rising there is a need for vigilance…The question is, will the Bank look back on this unprecedented period of extraordinary monetary policy and wish they had acted sooner? The path of inaction may seem easier today, but maintaining rates this low, for this long, could prove a much riskier decision tomorrow.”
hanges in the strength of the global economy will certainly have a role to play in forming the opinions of the Monetary Policy Committee and it will also be a key event when the Federal Reserve pushes up its interest rates. This is certainly an area to keep watching, as it’s not a question of if rates will rise, but when.
Articles
Bank of England dampens prospects of early UK rate rise BBC News (5/11/15)
Bank of England Governor gets his forward guidance on interest rates wrong Independent, Ben Chu (6/11/15)
Interest rates set to remain at rock-bottom right through 2016 as Bank of England cuts UK growth and inflation forecasts This is Money, Adrian Lowery (5/11/15)
Pound slides as Bank of England suggests interest rates will stay low for longer – as it happened 5 November 2015 The Telegraph, Peter Spence (5/11/15)
UK’s record low interest rates should be raised next Februrary says NIESE The Telegraph, Szu Ping Chan (4/11/15)
Fresh signs of slowdown will force interest rates rise to be put on hold The Guardian, Katie Allen (2/11/15)
The perils of keeping interest rates so low The Telegraph, Andrew Sentence (6/11/15)
Time to ask why we are still in the era of ultra-low rates Financial Times, Chris Giles (4/11/15)
No interest rate rise until 2017: Joy for homeowners as Bank of England delays hike in mortgage costs again Mail Online, Matt Chorley (5/11/15)
Pound tumbles after Carney warns its strength threatens recovery Bloomberg, Lucy Meakin (5/11/15)
Is Carney hurt by wrong rate steer? BBC News, Robert Peston (5/11/15)
Data and Reports
Inflation Report Bank of England (August 2015)
Inflation Report Bank of England (November 2015)
Historical Fan Chart Data Bank of England (2015)
Questions
- Use and AD/AS diagram, explain how low interest rates affect the key components of aggregate demand and in turn how this will affect economic growth.
- What is meant by the ‘yield curve’? How has it been affected by the latest release from the Monetary Policy Committee?
- Why has the value of the pound been affected following the decision to keep interest rates at 0.5%?
- How has the sterling exchange rate changed and how might this affect UK exports?
- What are the main concerns expressed by those who think that there is a danger from keeping interest rates low for too long?
- Why is the outlook of the global economy so important for the direction of interest rate changes?
People are beginning to get used to low oil prices and acting as if they are going to remain low. Oil is trading at only a little over $30 per barrel and Saudi Arabia is unwilling to backtrack on its policy of maintaining its level of production and not seeking to prevent oil prices from falling. Currently, there is still a position of over supply and hence in the short term the price could continue falling – perhaps to $20 per barrel.
