Transfer Pricing
September 1, 2015
September 25, 2015
Show all

Fall in oil prices – Its impact on global economy

Falling oil prices are one of the biggest event in the world influencing the global economy in both ways, positive and negative. The more prominent cause for the fall in the oil prices is the excess supply of oil which in addition is fuelled by weaker demand.

Lower demand from Europe, China and Japan due to slowing down and the start of the shale oil production in North America resulted in lower oil prices. The falling oil prices could have been controlled to some extent if supply had been reduced. OPEC countries which contribute about 40% of the world oil production having influencing power on oil prices by cutting or boosting the production also decided not to reduce oil production even though the prices are falling, due to fear of losing market share to players in North America. OPEC countries, specifically Saudi Arabia, hope that, if oil prices remain low for a longer time, these new players will not be able to sustain as their returns will not be sufficient to meet break-even and they will stop production. This will result in regaining the oil prices. Saudi Arabia can bear less revenue as they have huge foreign exchange reserves (approximately $750 billion in Jan’15, $685 billion in June’15) to finance deficits, but other OPEC members will not prefer low oil prices for longer time as they don’t have deep pockets and they may think of cutting the production. Russia, which has around 12% of total revenues from oil exports, also not cut the production.

The surprises have gone other way – in January, Russia and Iraq announced that they were exporting more oil than ever. This further reduced the prices to record low of $49 per barrel.

fall in oil prices 1

These falling oil prices impacted most of the economies. Biggest gainers are the emerging markets like India and China. These countries import major portion of their oil requirement. Because of the lowered prices, import bills are reduced, CAD is narrowed down and foreign exchange reserves are increased due to less spending on import bills. Inflation is also reduced as prices of most of the commodities and wages are directly or indirectly dependent on oil prices. So, central banks also eased the monetary policy and reduced interest rates to some extent which will help in boosting the investments and hence the growth. The government has also taken benefit by cutting the oil subsidies and increasing the oil taxes to improve public finance. Negative impact for India, if these low oil prices continued for significantly longer duration can be lower revenues from the export of refined oil products.

fall in oil prices 2 fall in oil prices 3

Another economy which benefited from lowered oil prices is the US. Because of low oil prices, people will have more money to spend on other things which will boost the growth. The US may have a negative impact, if this fall in prices continued. The oil producing states in the US will stop producing, which may result in loss of revenue and economic activity.

The economies which are greatly impacted in a negative way are the oil exporting countries like OPEC countries (Saudi Arabia, Iran, Venezuela, Iraq etc) and Russia. The impact is more significant as compared to that for oil importing countries. This is because; all these countries are more dependent on oil revenues. For example, Saudi Arabia has 90% of their revenues from oil. Russia has 45% of their revenues from oil.

Russia lost its revenues through oil exports. According to some estimates, its GDP will shrink by 4% in 2015 if oil prices continue at $60 per barrel. Also, falling oil prices caused the value of Ruble to collapse, imports to become expensive, inflation to rise. So, the central bank intervened and interest rates are raised to 17% from 10.5%. This again created volatility in the stock markets all over the world. The interest rate hike may slow down the Russia’s growth even further because the higher cost of capital will reduce investments.

Other economies which are negatively impacted are the Euro countries and Japan. These economies are already facing the problem of deflation. And low oil prices will further aggravate the situation. Interest rates in EURO area and Japan are already zero, so the capability of this tool (interest rate) is limited. So, the rise in oil price will help to create inflation. So, the rise in oil prices will be helpful to improve the situation in these economies.

Taking a holistic view of the impact of falling oil prices on the world economy, central banks and governments will have to make cautious policies which will be beneficial for achieving global economic stability. While doing so, one of the most volatile factors or one of the greatest risk i.e. geopolitical happenings in Gulf region needs to take into account.

Source for images / graphs: