Thursday, February 4, 2016

The Impact of Low Oil Prices on the Global Economy

We've all seen oil prices do this over the past two years:

...and have heard many pundits, economists and experts pontificate about the impact of low oil prices on the economy of the United States, Europe and the world's largest oil producing nations.  While the size of the economic impact is mainly conjecture and, at best, descriptive, two economists working under the auspices of the Federal Reserve Bank of Dallas have actually quantified the global macroeconomic consequences of falling oil prices.

In their paper "The U.S. Oil Supply Revolution and the Global Economy", Kamiar Mohaddes and Mehdi Raissi, use a Global VAR (vector autoregression) model to measure how the U.S. oil  supply revolution, which has created a global low oil price environment, has impacted the economies of both oil importing and oil exporting nations.  Obviously, overall spending in the economies of oil producing nations will decrease along with oil prices with an accompanying increase in overall spending by oil importing nations.  In the paper, the authors examine the macroeconomic consequences of the oil shale revolution on the global economy and on the Middle East and North Africa (MENA) region, the globe's main oil producing region, in particular, measuring the impact on real economic output and financial markets. 

In their model, the authors make the broad assumption that oil prices fell by 51 percent in the first year and rebound somewhat to 45 percent below the pre-shock levels in the second year.  For laypersons, the Global VAR methodology used by the authors would be considered hieroglyphical as shown here:

To spare you any additional pain that results from high end regressive analysis, with your kind permission, I will skip to the authors' conclusions.   Let's look at a series of figures showing the impact of the U.S. oil supply revolution on real economic output for a series of nations and economic regions with the horizontal axis showing time in quarters (i.e. 3 month periods) and the vertical axis showing the percentage point increase/decrease in real output.  First, we'll start with the economies that expand thanks to the increased supply of U.S. oil with the median data points found on the blue solid line:

Oil importing nations typically experience a long-lived rise in economic activity ranging between 0.04 percent and 0.95 percent in response to the United States supply-driven drop in oil prices.  It is interesting to see that China's economy experiences a far lower increase in growth thanks to oil prices than the other economies.  This is largely because China is heavily dependent on coal, rather than oil, for its energy needs, using coal for 66 percent of its primary energy needs compared to only 18 percent for oil in 2014.  In the case of the United States, 36 percent of its energy needs are derived from oil and only 20 percent are derived from coal so lower oil prices will have a more significant impact on its economic growth level.

Now, let's look at the economies that will contract thanks to the increased supply of U.S. oil:

For the countries of the Gulf Cooperation Council or GCC (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates), long-term economic activity drops by 2.14 percent, by 1.32 percent for the Middle East and North Africa or MENA nations and -0.41 percent for Latin America because lower oil prices weaken domestic demand and fiscal balances within these nations.  As well, a smaller fall in real economic output of 0.28 percent is experienced by oil importing nations within the MENA group since the economies of MENA's oil exporters and oil importers are strongly linked as you can see on this figure:

Focusing in more detail on the MENA region, we find that the U.S. oil supply revolution has this impact on real output a nation-by-nation basis as shown on this figure:

As you can see, the negative economic impact of lower oil prices has been and will continue to be felt by the oil exporting nations of Iran and Algeria whereas the oil importing nations experience a far lower negative impact.

All in all, real global economic growth increases by between 0.16 and 0.37 percentage points thanks to lowered oil prices that result from the U.S. shale oil revolution.  This is largely because the drop in spending in oil exporting nations is exceeded by the increase in spending by oil importing nations.

Obviously, the significant change in the pattern of wealth transfer from oil producing to oil importing nations in the current low oil price environment has been quite positive for many oil importing economies and the global economy as a whole.  With the current sustained post-Great Recession period of very low economic growth rates, a boost of 0.5 percentage points in real economic growth is looking more and more like a one-time windfall for some economies, however, as the authors' calculations show, we can no more count on low oil prices for increased levels economic growth than we can count on central bankers to implement policies that actually create lasting economic expansions.   As well, there is a caveat for policymakers and governments; that oil prices can reverse themselves and rise as quickly as they dropped, putting a sudden halt to this expected economic bonus.

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