Six reasons why we should not invest too much hope in lower oil prices

The crude oil price halved from $105/barrel on 1 July 2014 to less than $50/barrel in January 2015 – an unprecedented fall that will have repercussions beyond the energy sector. In value terms, oil is the most important raw material for EU economies, and in 2013 the EU consumed about 4 billion barrels. At an average price of $100 this translated into $400 billion of EU final oil consumer spending or 2.2 percent of EU GDP. A more-or-less halving of the price therefore saves EU oil consumers an equivalent of about 1 percent of EU GDP. There are also knock-on effects on other energy costs directly or indirectly linked to oil prices, such as oil-indexed gas contracts.

All this has raised hopes of an economic dividend in the EU, an idea that might be supported by the apparent relationship in many economies over the past 60 years between the oil price change in one year and economic growth in the subsequent year. We have calculated the linear relation between the annual change in the logarithm of the real oil price in USD and the change in the logarithm of real GDP for different countries and regions – see the table. Oil exporters such as the Arab countries have tended to have a higher real GDP in the year following an oil price increase. Meanwhile, growth in the rich oil importers (such as OECD countries) has tended to be two to three percent lower when the oil price doubles, compared to years without a change in the oil price. If predictions could be made on the basis of this apparent correlation, it would mean that the EU economy might grow 2 percentage points faster when the oil price halves. However, even ignoring all the methodical issues of such a simplified regression model, the correlation between oil prices and economic growth is not universal – the rather low confidence level (a p-value of more than 5 percent is typically considered as not statistically significant) shown in the table indicates that the oil price alone is not very helpful in predicting GDP.

Table: Coincidence of oil-price changes and real GDP changes 1962-2014 for selected regions (sorted by confidence)

In fact, for the EU, there are six reasons to think that the growth dividend from a low oil price might be rather limited:

1) Falling oil prices might have less of an impact than rising oil prices

2) Decreasing importance of oil prices on the macro economy

3) The current economic environment reduces further the impact of a negative price shock

4) The demand-side part of the oil price shock indicates a lesser impact on the economy

5) Deterioration of terms-of-trade limits the impact on production, investment and employment

6) The political fall-out for oil exporters carries some economic risk

Map: Coincidence of oil-price changes and real GDP changes 1962-2014

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Source: Bruegel based on data from World Bank and BP Statistical Review of World Energy

•   Falling oil prices preceed rising GDP, significant
•   Falling oil prices preceed rising GDP, not significant
•   Falling oil prices preceed falling GDP, significant
•   Falling oil prices preceed falling GDP, not significant

Falling oil prices might have less of an impact than rising oil prices

According to Hamilton (2009) the 2007-08 oil price surge, when prices increased from about $50/barrel to almost $150/barrel in 18 months, contributed to the subsequent recession in the US. In contrast to 2007-08, we are currently confronted with a massive price slump. But do negative oil price shocks have impacts that are symmetrical to the much better researched positive oil price shocks? Mork (1989) shows that rising prices have a stronger impact on GDP than falling prices, a finding that is confirmed by Lardic and Mignon (2008). According to this asymmetry, the impact from the current oil-price slump should be less.

[NB: But this finding is not undisputed. A contrary argument holds that the size of the shock matters. Huang et al (2005) demonstrate that oil prices and oil price variability needs to cross a threshold for oil shocks to be significant. Kilian (2012) wonders whether asymmetries found earlier might be the result of these threshold effects. If this were the case, the current massive oil price drop might have as significant effects as a similar-sized oil price increase.]

Decreasing importance of oil prices on the macro economy

Gregorio et al (2007) find that the effects of oil shocks on inflation and output has weakened. They argue that among the factors that might help to explain this decline, the most important are a reduction in the oil-intensity of economies around the world, a reduction in the exchange rate pass-through and a more favourable inflation environment. Also, the increase in wage flexibility, introducing flexible exchange rates, opening up and liberalising global trade and augmenting the power of monetary policies in order to fight inflation might have played a role (Chen, 2009).

And indeed, when splitting the full sample (1962-2014) in the middle (1992/93) we find that after 1992 the impact substantially decreased. The average positive beta coefficient decreased from 0.038 to 0.026 and the average negative beta coefficient increased from -0.033 to -0.020. For the European Union, the coefficient after 1992 indicates that a halving of the oil price coincides with 1.1 percent higher real GDP (ß= -0.0109) but we in fact have no confidence that the impact is significant (p=0.57).

Map: Coincidence of oil-price changes and real GDP changes before and after 1992/1993

Before 1993

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After 1992

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Source: Bruegel based on data from World Bank and BP Statistical Review of World Energy

•   Falling oil prices preceed rising GDP, significant
•   Falling oil prices preceed rising GDP, not significant
•   Falling oil prices preceed falling GDP, significant
•   Falling oil prices preceed falling GDP, not significant

The current economic environment reduces the impact of a negative price shock further

As Europe has introduced many of the previously mentioned economic policies that weaken the oil-growth link, such as inflation targeting, wage flexibility and trade-opening, negative oil price shocks are less likely to translate into lower inflation and higher output than in the past.

In addition, Lee et al (1995) argue that oil price changes have a bigger impact in an environment with little variability than in an already volatile environment. During periods of high price variability, oil price changes are not believed to embody important new information and seem not to trigger the same impact as changes during low variability periods. According to this, the highly volatile environment might be another reason why the current slump in oil prices might have a more limited impact on economic growth.

The demand-side part of the oil price shock indicates a lesser impact on the economy

Kilian (2008) argues that the nature of the oil shock is important: higher oil prices resulting from increased economic activity in some parts of the world (demand shock) tend to coincide with subsequent economic growth in all parts of the world. However, higher oil prices resulting from unexpectedly low production (supply shock) coincide with subsequent lower economic growth. Reversing the argument means that lower oil prices because of higher-than-expected oil production would be most effective in stimulating growth in Europe.

The current shock, however, seems to be a mixture of lower-than-expected oil demand because of sluggish growth and higher-than-expected oil production in some crisis regions (Iraq, Libya) and strong oil production growth in the US. Consequently, the positive economic stimulus arising from the current fall in oil prices can also be expected to be more modest than if it were solely due to unexpected supply hitting the market.

Deterioration of terms-of-trade limits the impact on production, investment and employment

Academic literature does not find a significant positive impact of low oil prices on general business investment. Only in mining and the oil industry itself are investments negatively affected by low prices (Edelstein and Kilian, 2007).

In terms of employment, the effect of oil prices also depends on the sector. Some jobs, such as wind turbine manufacturers or insulation producers are a substitute for oil imports. They are obviously less in demand when the oil price goes down. The productivity of other jobs increases with lower oil prices – truck drivers are an illustrative example. Thus there will be increased labour demand in this sector. The overall effect of oil prices on employment seems to be small (Keane and Prasad, 1996).

Bodenstein and Guerrieri (2007) find evidence that with imperfect financial markets, oil-importing countries have to depreciate their currencies to export more goods in order to be able to import the more expensive oil. In case of falling oil prices this would suggest that the non-oil exports of oil importers would fall, while wealth increases.

The political fall-out for oil exporters carries some economic risk

Low oil prices have an impact on the public budgets of oil-exporting countries. These countries will be faced with a trade-off between deficit-spending and austerity. In countries without vast sovereign wealth funds, the room for deficit spending is limited. But tough austerity might destabilise the political systems in these countries and in some cases even propel regional conflicts, which in turn might have negative impacts on the world economy.

In addition, most of the money of sovereign wealth funds has been parked in the financial system of oil-importing economies (such as the EU). Withdrawal of these funds to finance the state budgets of oil exporters might have repercussions for the financial systems in the oil-importing economies.

Conclusion

The falling oil price will have a major impact by shifting production and investment between sectors (from energy-efficient to oil-intensive, from oil industry to the rest of the economy). It will also shift substantial wealth – in the order of half of global oil export revenues in 2013: $1 trillion – from oil-exporting countries to oil-importing countries.

But the aggregate impact might be smaller than suggested by the sectoral effects, the historical data and some media fanfare, for the six reasons we have discussed.

Even if the oil price continues to hover around $50, it is unlikely to add more than one percentage point of growth to the EU economy. Given all mitigating factors, the effect is likely to be even less. Growth in the EU in 2015 will be mainly driven by factors other than the oil price.

Research Assistance by Burak Turkoglu is gratefully acknowledged. 

Read more on oil prices:

The price of oil in 2015

The new oil price war