Traditionally we have believed oil price declines would provide a net positive boost for the world economy, the balance between a negative effect on the growth of exporters more than offset by a positive effect for importers. Instead, we have seen a strong positive relationship between the oil price and equity markets, with a near doubling of the correlation. Those same equity markets have broadly reflected the continuing difficult conditions we find ourselves in post-crisis.
We might need to differentiate between oil price declines brought about through an increase in global supply versus those that occur due to a drop in global demand. The latter phenomenon could partly explain what we have observed – slowing global growth cushioned by lower oil prices. Indeed, recent studies suggest slowing global demand may account for as much as a half to a third of the oil price fall. For lower oil prices to feed through to positive growth, one would typically expect a boost in spending, but we have not seen any evidence this time – rather, public investment has been falling, and many countries have no capacity for any additional borrowing to provide stimulus.
And the size of the decline has had a direct effect on oil and gas capex too, with knock-on effects to other parts of the economy. Following the crisis, central banks pursued unconventional policy of one form or another – leaving no capacity to further rate cuts to support growth alongside the reduction in oil price. A fall in long-term inflation expectations can feed through to stifle the increases in output and demand we would otherwise expect. The failure of producers to agree to hold output steady obviously weighs heavily upon the supply problem in the short term, but there is reason to hope the oil drop will ultimately be expansionary.
Today’s price war is holding the price down, but eventually we should see a fall in supply and a higher price. This current episode of lower oil has come at an unusual, and to some extent unprecedented, time. As such we have seen unexpected dislocations and feedback loops requiring us to reconsider the effects of lower oil, at least in the short term.