Why the oil price plunge holds promise and peril

An understanding of the long- and short-term factors that were behind the recent plunge in oil prices is essential for all with an interest in economic policy, given that we still live in the age of oil.

Today my team has published a paper that looks into how the rapid expansion of oil supply from unconventional sources, OPEC’s change of strategy, and weak global demand drove the decline in oil prices.

These underlying forces are buoyed by a strengthening U.S. dollar and the fact that oil production in the Middle East has not been severely disrupted by ongoing conflict, though of course that could change abruptly and the volatility in the region is extremely troubling.

Authored by John Baffes, Ayhan Kose, Franziska Ohnsorge, and Marc Stocker, the paper is the first in a new series of Policy Research Notes (PRNs), which I hope will grab hold as a go-to source for well-synthesized analysis that sheds light on issues of contemporary policy concern.

The close to 50 percent drop in the price of oil between June 2014 and February 2015 may mark the end of the commodity price super cycle that began in the early 2000s. Of course, we’ve seen such plunges before; the latest episode has some significant parallels with the price collapse in 1985-86, which also followed a period of strong supply of unconventional oil and the eventual decision by OPEC to forgo price targeting.

Unconventional and higher-cost oil producers (i.e. US shale, Canadian oil sands and global biofuel production) may well become the new swing, or influential, producers in the oil market. While volatility in oil markets will likely persist, prices are expected to remain soft over the next few years.

Our estimate is that a decline in oil prices of about 50 percent could be associated with a 0.7-0.8 percent increase in global GDP over the medium term. The impact on economic activity will, of course, vary across countries, especially depending upon whether they are net oil importers or exporters.

Low oil prices should push down prices for natural gas, fertilizers, and food commodities. Cheaper food should benefit a majority of the world’s poor, who are net consumers. With more than 70 percent of the world’s poor living in oil-importing countries, low oil prices should help in the drive to reduce global poverty.

The poor could gain further if falling oil prices allowed expenditures on fuel subsidies to be reallocated to better-targeted pro-poor programs, a point I also made in my recent Project Syndicate op ed co-authored with World Bank Managing Director Sri Mulyani Indrawati. We also stress that now is an opportune time to switch or fix fuel price regimes so that they are more responsive to market movements.

So if policymakers respond intelligently, the oil price decline should be a plus for global growth and poverty reduction. It, however, entails painful adjustment in some oil-exporting countries. Even putting aside the losses that occur when profits plunge due to a price drop, we know all too well that an abundance of “black gold” can quickly turn into a natural resource curse for those countries that fail to diversify.

Oil price developments can add to volatility in financial and currency markets, as we’ve already seen in recent months. Also, while cheap oil is a boon for the world economy overall, it could complicate monetary policy making in economies that are already grappling with strong deflationary forces.

There is also peril inherent in the lure of cheap oil, which is already leading to more SUV purchases, longer family road trips, and generous use of diesel generators in homes. To dampen the urge that many may have to go on a fuel consumption binge, while at the same time building fiscal space, policymakers could consider raising fuel taxes where appropriate.

Unless we seize the opportunity offered by low oil prices and do the right thing now by taking the longer view, our collective goals of promoting cleaner energy and combating climate change could be seriously set back.

After all, at some point, the age of oil may end and we will need to be ready.

This article was first published by the World Bank’s Let’s Talk Development blog. Publication does not imply endorsement of views by the World Economic Forum.

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Author: Kaushik Basu became Senior Vice President for Development Economics and World Bank Chief Economist on October 1, 2012.

Image: A petrol pump is seen at Tesco’s in Leeds, northern England, June 25, 2010. REUTERS/Nigel Roddis.