Sunday, January 10, 2016

Falling oil prices: is greater supply or falling demand the problem?

Oil prices are heading towards $30. Is this good or bad?

Well, the answer depends on what the underlying cause is. If greater supply is the reason, then it's good. Input prices fall for a given level of demand. This makes consumers and producers richer, increases consumer spending, investment and exports and pushes up aggregate income. If, however, falling demand is the reason, a fall in oil prices is bad news. It's a sign that global growth is slowing down.

Stephen King of HSBC argues that it's the latter factor at the moment. It's not greater supply, whether shale production in the US or greater Saudi, Iran and Russian production, that's the cause. Why does he say that? Because, while there's some increase in consumer spending, investment and exports aren't growing months after the oil price decline set in. And much of the fall in demand is caused by China:
The cause of the inward shift in the demand curve is, more than anything else, the slowdown in Chinese economic growth. In every year since 2012, initial projections for Chinese growth have been too high. Part of the slowdown is self-administered, a reflection of Beijing’s attempt to deflate a property investment bubble. The rest reflects both weak demand elsewhere in the world and, until recently, a dramatic appreciation in the renminbi’s value on the world’s foreign exchanges: both have seriously limited China’s export performance. As the world’s second-largest economy, biggest infrastructure investor and dominant commodity consumer, China’s slowdown has had enormous global repercussions — from a Brazilian recession through to persistent deflation and incredibly low borrowing costs.
I would go along with that. Yes, falling global demand is the primary reason for falling oil prices. But that doesn't explain why the Saudis and others should not be cutting back on oil production. Why are they almost perversely pushing oil prices even lower? It's not plausible that the Saudis are doing this to hurt shale producers in the US: the Saudis dare not threaten US interests.

No, lower oil prices are intended to hurt Russia and Iran, to weaken them economically. So, falling oil prices are not entirely a demand-side issue today. As I have been saying in several posts, geo-politics is at work.




4 comments:

Anonymous said...

In either case its a good time for India to build an Oil Reserve. We should be able to use a part of savings to keep on stocking up to secure our energy interests. As it is speculation increase in exaggerating the price ... we never know if the oil prices rebound which it will after some time how speculation will play out

- Deepak

T T Ram Mohan said...

Well, yes, this seems a good idea especially given that our current account situation is favourable. But the oil companies must pay given that the government faces a budget constraint.

TTR

Anonymous said...

On the point you make regarding why the Saudis are not cutting oil production I have two points and I was wondering what your thoughts are on it..

- You say the Saudis are primarily targeting Russia and Iran with lower oil prices and that as allies they are not targeting US shale gas production.
But isn't it true that US shale gas production is one of the reasons behind US energy independence. Since it is no longer dependent to such a great extent to the Middle East for its energy needs, it has enabled the Obama administration to withdraw from playing too active a role in recent Middle East politics. This is something that the Saudis are not too happy about because it loses its biggest leverage in US-Saudi bilateral ties. It is also because of this cooling off that Obama could make the overtures to Iran which resulted in the Iran deal and the end of isolation of Iran from the oil markets that cannot have made the Saudis happy.
By keeping prices down, it makes shale gas production uncompetitive and brings back the US to the Middle east and by extension to its biggest ally there, the Saudis for its energy needs. Something the Saudis would be most keen to see develop as the sectarian tensions in the Middle East escalate. The interview of the deputy crown prince of Saudi Arabia in the recent issue of Economist makes the point how much the Saudis would like the US to once again play a much bigger role in Middle eastern politics

-- My second point is that as the largest producer in the Middle East, the Saudis are reluctant to cut production in the face of falling prices because of their experience during the oil crisis of the 70s. As prices fell then, the Saudis took the lead in cutting production as the largest producer, but in the lag period that it took other producers to cut production, the Saudis also lost market share. They never regained the market share they lost when prices moved up again.

Your thoughts on this??
~SC

T T Ram Mohan said...

SC,

I am not sure the US has withdrawn from playing an active role in the Middle East. If that were their intention, they would have gone along with Russia's suggestion for a UN-led coalition against ISIS. I am also not sure US-Saudi relations have cooled a great deal. What the US is reluctant to do is put boots on the ground, as they did in Iraq and Afghanistan.

A cut in production will be at least offset by a rise in prices, which should work to the benefit of all oil producers. The Saudis appear to have calculated that they can withstand the impact of lower oil prices for a while but Russia and Iran will be impacted more.

TTR