Magazine article Management Today

Cheap Oil Augurs Ill

Magazine article Management Today

Cheap Oil Augurs Ill

Article excerpt

The steep price rises of 1973-74 and 1979-81 pushed the price of oil from under $5 a barrel in the early 1970s to nearly $40 in the early 1980s. The result for Western economies was a stagflationary mixture of rising prices and severe recessions. In recent years oil prices have generally been very weak. From a 1984-85 price of around $28 a barrel there was a precipitous fall in the first half of 1986 to prices as low as $10 and, despite subsequent recovery, even in 1988 prices have been below $15. Moreover, since early 1985 the dollar/pound exchange rate has fallen from $1.05 to $1.80. For Europeans and the Japanese in particular the real price of oil has fallen dramatically in recent years and the belief has gained ground that oil prices are no longer a problem worth worrying about - a significant decision for large net importers of oil. It can be argued, however, that such a view is much too optimistic if a medium term time horizon is adopted.

A review of recent developments in oil markets indicates the basic source of recent declines in oil prices. On the demand side it is certainly true that the industrialised countries have grown more slowly and have achieved a substantial reduction in their use of energy as a proportion of GDP. Nevertheless the more striking developments have been on the supply side of the market, as reflected in the growth of production of oil in non-OPEC countries and the associated loss of market share in both production and exports that OPEC experienced in the first half of the 1980s.

The decline in volume was severe and placed increasing strains on the OPEC cartel, particularly in the context of some members' pressing needs for revenue and repeated cheating on official quotas. By 1985-86 Saudi Arabia, with the largest oil resources in OPEC, not surprisingly judged its interests to be served no longer by continuing to support prices through holding back its own volume of production; the resulting decrease in prices meant that the value of OPEC oil exports in 1986 fell to its lowest level since 1973. In the past two years the OPEC producers have enjoyed some success in arranging quotas which have pulled prices up from their 1986 low in dollar terms despite the continuing Iran/Iraq difficulty, but the overcapacity in world oil supply implies that their 1970s market power has been largely eroded.

The November meeting of OPEC, at which the first 13-member oil production agreement in two years was ratified, showed that members can still resolve differences - even if compromise is essential. But even if the agreement sticks, most observers think the oil price will remain fairly low.

For most Western countries the recent declines in oil prices have been unambiguously good news in the short run. Table 2 reports a typical simulation result from a well known macroeconomic model of the effects to be expected from a 20% fall in oil prices in the mid-to-late 1980s. Even for Britain as an oil exporter the overall effects are distinctly favourable, although because of the impact of falling oil prices in lowering the exchange rate the gains in reduced inflation are, of course, much less. At the same time, the implication of the table is that a rise in oil prices has the scope to inflict uncomfortably large adverse effects on these economies.

EFFECT OF 20% FALL IN OIL PRICE
                  Year 1   Year 2   Year 3
GNP*
USA               0.1      0.6      1.1
Japan             0.4      0.9      1.2
Germany           0. … 
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