What is the impact of falling oil prices?

Oil prices have fallen significantly. Part of the plunge can be attributed to disappointing global growth and a stronger U.S. dollar. But supply factors are relevant, such as higher supply from conventional and non-conventional energy sources (shale oil in the U.S. and sand oil in Canada).

Most commodities have also fallen this year. Higher commodity prices during the past decade led to a boom in investments in most natural-resource sectors, which are now maturing and exerting downward pressure on prices. Oil, though, is underperforming other commodities. From its June 2014 peak to December 15, the price of a barrel of Brent crude oil is down by around 46%. In contrast, the CRB – the main benchmark for commodity prices – is down by 14% from its 2014 peak.

What sparked oil’s underperformance? We believe this is most likely related to the policies of OPEC. Surprisingly, production has not been reduced as a response to lower prices, as was typically the case in the past few occasions when oil prices dropped by a similar magnitude or more.

Our base-case scenario is that oil prices will recover some of their recent losses in the medium run, but they are unlikely to go back above USD 100 per barrel (Brent). We see Brent trading around USD 70 per barrel before year-end, a recovery from the current USD 60 per barrel price.

OPEC’s decision to not alter its output target resulted in a second wave of sharp price falls, probably because OPEC was interested in introducing more risk into the many potential energy projects around the world (like the ones in Latin America that we explore below). There are also geopolitical strategies involved, such as the desire to weaken some other oil-producing countries. The current reaction of OPEC to lower oil prices means that it can take longer for prices to recover partially.

Considering the highly uncertain outlook for oil prices, we explore in this report how vulnerable each of the LatAm countries within our coverage is to lower oil prices (Argentina, Brazil, Chile, Colombia, Mexico and Peru).

Colombia is the outright loser. Its net energy exports account for about 8.4% of GDP, while FDI to energy activities represents more than 50% of the total. Predictably, the Colombian peso has been one of the worst-performing currencies since oil prices started to fall.

Mexico is also on the losing end. Around one-third of the government’s fiscal revenues come from oil, and lower prices can reduce potential gains from the aggressive energy reform recently approved by the Mexican congress. In the short term, however, Mexico is protected from lower oil prices, as the government sets domestic gasoline prices, and even the small energy surplus run by the country is hedged by the government.

Argentina and Brazil benefit only in the short term. Both countries are currently net energy importers, but their Energy sectors have a lot of potential. The lower oil prices would hamper any meaningful exploration of their resources.

In our LatAm coverage, Chile is the clear winner from lower oil prices. Its energy net imports are almost 6% of GDP. Energy prices in Chile are also more flexible than in other countries. So, real household income would benefit from the lower oil prices.

Conclusion

Oil prices have fallen sharply. Our base-case scenario is that oil prices will recover some of their recent losses. However, the reaction function of OPEC to lower oil prices seems more unpredictable, so it may take much longer for prices to recover partially.

In a time of great uncertainty for oil prices, this report explores how sensitive each LatAm country within our coverage is to lower oil prices. Most have a significant exposure to oil. In the short term, Argentina and Brazil gain from a decline in prices, while Mexico’s losses are contained. However, in the medium to long term, Argentina, Brazil and Mexico have much to lose, as investments in their vast oil and gas reserves may suffer. Chile is the clear winner, while Colombia is the loser.

This article is published in collaboration with Breaking Views. Publication does not imply endorsement of views by the World Economic Forum.

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Author: Ilan Goldfajn is a Chief Economist at Itau Unibanco. Joao Pedro Bumachar is an economist at Itau Unibanco.

Image: An employee fills a test tube with mineral oil from the Vankor deposit owned by Rosneft company at a quality control laboratory of the Krasnoyarsknefteproduct oil product company in Krasnoyarsk, Siberia, October 10, 2014.