The Global and Domestic Implications of the Oil Price Decline

The Global and Domestic Implications of the Oil Price Decline

By Farai Gwaka (farai@zam.co.zw) 

The year 2014 was another extraordinary year on the global economic front with several key economic events taking place which will certainly have a lasting impact on growth and the overall economic outlook for 2015 and beyond. At the top of the list was the resurgence of the US economy which amplified the already strengthening US dollar against most major currencies, whilst on the other hand, the slowing of China’s growth to a projected 7.4% for 2014, a growth rate last seen in the early 1990s also marked an important turn of events in the world’s second largest economy.

However the most unexpected development during the year was the 45.39% decline in crude oil prices after nearly five years of stability from a Brent Crude price of $101.21/bbl. as at the 4th of September 2014 to a closing price of $55.27/bbl. as at the 31st of December 2014.

There have been several hypotheses put forward by leading experts to try and explain this phenomenon but in our opinion it all boils down to the supply, demand and expectations situation in the global oil market. On the supply side, key oil producers had been investing heavily during the years of high oil prices and this resulted in a significant boost in the global oil output. From September 2008 to September 2014 total global oil produced increased by 10.59% from 84.5 million barrels a day to 93.45 million barrels a day. The United States has become the world’s largest oil producer and as at September 2014 was producing 14.25 million barrels of oil per day whilst Saudi Arabia and Russia were second and third, producing 11.6 million and 10.6 million barrels per day, respectively. Although the US does not export crude oil, it now imports much less, creating a lot of spare supply.

America’s oil boom is well documented with shale oil production growing by roughly 4 million barrels per day since 2008. This has resulted in a cut in OPEC oil imports by half and for the first time in 30 years, the US has stopped importing crude from Nigeria.  Libya’s oil production which had for a while been hovering at around 150,000-250,000 thousand barrels per day because of internal strife, seems to have sorted out its disruptions much quicker than anticipated, and as at September 2014 was producing 834,110 barrels per day. Furthermore, Libyan officials were expecting production to surpass a million barrels per day by year end 2014 and 1.2 million barrels a day in early 2015. 

The Organization of Petroleum Exporting Countries (OPEC) shapes market expectations through altering supply and most recently in the face of increasing competition from shale oil producers, OPEC under the leadership of Saudi Arabia, deliberately increased its output to try to take out its high cost competitor. Saudi Arabia is the most influential member of OPEC because it produces over 10 million barrels a day, or a third of the OPEC total production. The Saudis and their Gulf allies have therefore decided not to sacrifice their own market share to restore the price, because if they curb production sharply, the main benefits would go to countries they detest such as Iran and Russia. Saudi Arabia can tolerate lower oil prices quite easily, plus the oil rich nation has US$900 billion in reserves as a buffer. Saudi Arabia’s cost of getting oil out of the ground is as low as $5-6 per barrel, whilst their shale oil counterparts are at a cost of $60-70 per barrel. Furthermore, shale oil wells are short-lived as output can fall by 60-70% in the first year of production, therefore any slowdown in investment as a result of weak prices will quickly translate into falling production.

However, in the long run analysts believe that the shale industry’s future seems assured as fracking, in which a mixture of water, sand and chemicals is injected into shale formations to release oil, is a relatively young technology, and it is still making big gains in efficiency. In addition developing big conventional oilfields especially in inaccessible spots, deep below the ocean, high in the Arctic, or both costs billions of dollars whilst by contrast, a shale oil well can be drilled in as little as a week, at a cost of only $1.5 million, which is a huge difference. 
On the demand side, weak global economic activity, increased efficiency in the consumption of oil byproducts, and a growing switch away from oil to other fuels has reduced the growth in demand for oil. The negative European economic outlook as a result of financial fragmentation, high unemployment, structural rigidities, and unresolved fiscal challenges are likely to dampen the recovery. According to the International Monetary Fund (IMF) growth in the Euro Area is expected to be 1.1 % in 2015, and 1.6 % in 2016–17 which will adversely affect the demand for oil. Furthermore, demand for oil is expected to be lukewarm in Asia with a number of countries in that region cutting energy subsidies, resulting in higher fuel costs despite a drop in global oil prices. In 2012, Asia’s top spenders on energy subsidies, as a percentage of GDP included: Indonesia 3%; Thailand 2.6%; Vietnam 2.5%, Malaysia 2.3%, and India 2.3%. India is a primary example where between 2008 and 2012, the country’s diesel demand grew between 6% and 11% annually. Since January 2013, the country has been cutting the subsidies on diesel which has flattened the demand for diesel. The implications of this sudden drop in the global oil price have been negative for the producers whilst positive for importers or consumers.

For the American frackers who borrowed heavily on the expectation of continuing high prices, as well as western oil companies with high-cost projects involving drilling in deep water or in the Arctic, the outlook is negative. This development has prompted the world’s biggest oil companies to announce a series of investment cuts as the current oil price and outlook does not support drilling activity. The International Energy Agency (IEA) projects non-OPEC oil supply to grow by 3.4 million barrels per day to 60 million barrels per day by 2020, at an annual average of 570,000 barrels per day. This is significantly lower than growth of 1 million barrels per day over the past five years and record growth of 1.9 million barrels per day in 2014. Furthermore, oil exporting countries in which governments had become dependent on high oil prices to pay for costly foreign ventures and expensive social programmes have also under the current weak prices found  themselves in deep trouble. The ruble tumbled by 72.3% against the US dollar as Russia’s prospects darkened further whilst Nigeria has been forced to raise interest rates and devalue the Naira. 

However, for oil importing countries the fall in oil prices will have a positive impact on growth. Economists believe that whenever the price of oil exceeds $100 per barrel, global growth struggles. Weak oil prices support economic activity and reduce inflationary, external, and fiscal pressures. Historical estimates suggest that a 30% decline oil prices could be associated with an increase in global GDP by about 0.5%. Furthermore, according to The Economist, a $40 price cut in the oil price shifts an estimated $1.3 trillion from oil producers to consumers. For example, the typical American motorist, who spent $3,000 in 2013 at the pumps, might be $800 a year better off in 2014/15 which is equivalent to an overall 2% pay rise. A country’s average daily petroleum consumption is often a good benchmark of the level of economic activity in that country.

Zimbabwe’s petroleum consumption trend from independence in 1980 to 2013 has been a roller coaster ride with several ups and downs during the period. According to statistics from the Energy Information Administration (EIA), in 1980 the country’s average daily consumption was 12,800 barrels per day with consumption growing since then to a peak of 31,000 barrels per day in 1999. Since 1999 petroleum consumption sharply declined each year to a record post-independence low of 12,500 barrels per day in 2009. With the inception of the multi-currency regime, petroleum consumption has been on the increase, peaking in 2012 at 20,970 barrels per day, before declining to 19,010 in 2013. Given the further economic slowdown in 2014 we expect the average daily petroleum consumption to further decline. Such statistics clearly highlight the extent of the economic meltdown that took place in the country over the last decade and a half. Ghana which was at par with Zimbabwe in terms of petroleum consumption per day in 1980 up to the late 1990s was as at 2013 consuming 66,570 barrels per day and is currently at a gross domestic product (GDP) of US$48.14 billion or $1,770 per capita, according to the World Bank.  Zimbabwe because of the lost decade shrunk to a GDP of $13.49 billion or $860 per capita, according to the World Bank. In 2013 Zimbabwe consumed an average 19,010 barrels of petroleum products per day which translates to 3,022,348.38 litres per day.  Using the same consumption rate for 2014/15, this implies that the 7% to 8% decline in domestic petrol and diesel prices translated to an estimated $132.4 million in savings for petroleum consumers in the country or $9.81 per capita. Such a saving in our opinion is huge, as it is similar to a $132.4 million capital injection into the economy at a time when the economy is in need of a stimulus. From an inflation perspective, this decline in petroleum prices will definitely have a marked impact as transport whose main input is fuel, has a weight of 9.8% in the country’s CPI basket. We therefore believe that the current deflationary trend will persist on the back of the decline in fuel prices going forward. Furthermore, we also believe that given the fact that the US dollar is estimated to be 20% overvalued in Zimbabwe, deflation is actually a good thing for the country as it forces the country’s productive sector to be more efficient. Truth be told, some of the margins that local producers were working with were inherited from the hyperinflationary mindset. The new US dollar reality requires the implementation of global industry best practices across all aspects of business, as failure to do so will result in the ultimate collapse of these industries or businesses. The reduction in petroleum fuel prices also translates to a marginal increase in household real incomes for Zimbabwean consumers which cannot be ignored.

However, looking at the continued company closures and company retrenchments, the benefits of such increments in real income are quickly dissipated by these negative forces. We already expect to see a poor December 2014 and March 2015 reporting season on the Zimbabwe Stock Exchange, which in our opinion will further confirm the extent of the acute decline in overall real disposable incomes and household consumption. The country’s current account position is also expected to improve as a result of the decline in the price of oil on the global market. Zimbabwe’s trade deficit shrank by 14% from US$3.9 billion in 2013 to US$3.3 billion in 2014, on the back of a slowdown imports. Whether this slowdown in imports was a function of increased duties on imports or a slump in aggregate demand or both, is yet to be confirmed. However the strengthening US dollar coupled with subdued international commodity prices are likely to continue having a negative impact on the country’s exports, which may offset the gains from the reduction in fuel importation costs. Government will most probably be the only clear beneficiary of the decline in petroleum prices after it used the decline as an opportunity to increase its excise duty on both petrol and diesel imports. The excise duty on petrol was adjusted from $0.35 to $0.45 per litre, while that for diesel was adjusted from $0.30 to $0.40 per litre. According to our estimates this will translate to a 31.25% (or $110.3 million) increase in fuel excise tax revenue from $353 million per annum to $463.3million per annum, which is huge. Had this tax increase not been effected the benefit of the fall in oil prices to local petroleum consumers or households would have been close to $242.7 million or $18 per capita according to our estimates.However, the question that remains to be answered is that, will the $110 million which government expects to raise from the new excise duty on fuel benefit the overall economy in government coffers or should this $110 million have gone to the petroleum consumers or productive sectors through an additional 10 cent fuel price cut?  To answer this question we look at the likely transmission mechanisms that both sides would use to spend the $110 million wind fall. Government on one side would probably spend a large portion of the funds on civil servant salaries which currently account for 80% of total government expenditure, with the balance going to operational expenses and the servicing of debt. We don’t anticipate that any of the funds will be spent on capital expenditure given the still tight fiscal space. However, because there will be no incremental benefits to civil servants, for example, a salary increment as a result of the upturn in tax revenue, this therefore means that their spend will remain unchanged and impact of the $110 million on the broader economy will be zero.  However if the $110 million was injected into the economy through a further 10 cent decline in fuel prices, this would translate according to our estimates to a $264 per annum saving on fuel costs per every 100 litres of petrol or diesel purchased by local petroleum consumers. This extra disposable income for households would have a positive effect on both consumption and savings which will boost corporate revenues and profits whilst also increasing the country’s deposits base. However given the country’s high affinity for imports, sadly a portion of the increment in disposable incomes will leave the country in the form of increased imports.

Corporations would also benefit from the lower fuel costs as this would significantly improve their cash flow positions especially for businesses where fuel or distribution costs are high. Corporates would also benefit from increased household demand, all of which would result in improved performance and profitability. Government under this scenario could also benefits from increased tax revenue on both consumption and corporate profits. The upside for government will not be as high as the direct tax on fuel, but the momentum created by the fuel price decline on the broader economy will overtime coupled with other progressive policies increase government’s tax revenue.

 In conclusion, lower oil prices if sustained will have a positive impact on global growth especially for oil importing countries such as Zimbabwe. With government total recurrent expenditure now at 92% of total expenditure, the windfall from oil provides government with an opportunity to rebalance its fiscal position and hopefully avoid a possible default in civil servant salaries which we expect to see in the latter part of 2015. For petroleum consumers and households the oil windfall was marginal and we think its impact on the broader economy will not be as pronounced as initially anticipated. Our overall economic outlook for 2015 therefore remains negative, given the continued deterioration of the country’s economic fundamentals. 

The Global and Domestic Implications of the Oil Price Decline

The Global and Domestic Implications of the Oil Price Decline

By Farai Gwaka (farai@zam.co.zw) 

The year 2014 was another extraordinary year on the global economic front with several key economic events taking place which will certainly have a lasting impact on growth and the overall economic outlook for 2015 and beyond. At the top of the list was the resurgence of the US economy which amplified the already strengthening US dollar against most major currencies, whilst on the other hand, the slowing of China’s growth to a projected 7.4% for 2014, a growth rate last seen in the early 1990s also marked an important turn of events in the world’s second largest economy.

However the most unexpected development during the year was the 45.39% decline in crude oil prices after nearly five years of stability from a Brent Crude price of $101.21/bbl. as at the 4th of September 2014 to a closing price of $55.27/bbl. as at the 31st of December 2014.

There have been several hypotheses put forward by leading experts to try and explain this phenomenon but in our opinion it all boils down to the supply, demand and expectations situation in the global oil market. On the supply side, key oil producers had been investing heavily during the years of high oil prices and this resulted in a significant boost in the global oil output. From September 2008 to September 2014 total global oil produced increased by 10.59% from 84.5 million barrels a day to 93.45 million barrels a day. The United States has become the world’s largest oil producer and as at September 2014 was producing 14.25 million barrels of oil per day whilst Saudi Arabia and Russia were second and third, producing 11.6 million and 10.6 million barrels per day, respectively. Although the US does not export crude oil, it now imports much less, creating a lot of spare supply.

America’s oil boom is well documented with shale oil production growing by roughly 4 million barrels per day since 2008. This has resulted in a cut in OPEC oil imports by half and for the first time in 30 years, the US has stopped importing crude from Nigeria.  Libya’s oil production which had for a while been hovering at around 150,000-250,000 thousand barrels per day because of internal strife, seems to have sorted out its disruptions much quicker than anticipated, and as at September 2014 was producing 834,110 barrels per day. Furthermore, Libyan officials were expecting production to surpass a million barrels per day by year end 2014 and 1.2 million barrels a day in early 2015. 

The Organization of Petroleum Exporting Countries (OPEC) shapes market expectations through altering supply and most recently in the face of increasing competition from shale oil producers, OPEC under the leadership of Saudi Arabia, deliberately increased its output to try to take out its high cost competitor. Saudi Arabia is the most influential member of OPEC because it produces over 10 million barrels a day, or a third of the OPEC total production. The Saudis and their Gulf allies have therefore decided not to sacrifice their own market share to restore the price, because if they curb production sharply, the main benefits would go to countries they detest such as Iran and Russia. Saudi Arabia can tolerate lower oil prices quite easily, plus the oil rich nation has US$900 billion in reserves as a buffer. Saudi Arabia’s cost of getting oil out of the ground is as low as $5-6 per barrel, whilst their shale oil counterparts are at a cost of $60-70 per barrel. Furthermore, shale oil wells are short-lived as output can fall by 60-70% in the first year of production, therefore any slowdown in investment as a result of weak prices will quickly translate into falling production.

However, in the long run analysts believe that the shale industry’s future seems assured as fracking, in which a mixture of water, sand and chemicals is injected into shale formations to release oil, is a relatively young technology, and it is still making big gains in efficiency. In addition developing big conventional oilfields especially in inaccessible spots, deep below the ocean, high in the Arctic, or both costs billions of dollars whilst by contrast, a shale oil well can be drilled in as little as a week, at a cost of only $1.5 million, which is a huge difference. 
On the demand side, weak global economic activity, increased efficiency in the consumption of oil byproducts, and a growing switch away from oil to other fuels has reduced the growth in demand for oil. The negative European economic outlook as a result of financial fragmentation, high unemployment, structural rigidities, and unresolved fiscal challenges are likely to dampen the recovery. According to the International Monetary Fund (IMF) growth in the Euro Area is expected to be 1.1 % in 2015, and 1.6 % in 2016–17 which will adversely affect the demand for oil. Furthermore, demand for oil is expected to be lukewarm in Asia with a number of countries in that region cutting energy subsidies, resulting in higher fuel costs despite a drop in global oil prices. In 2012, Asia’s top spenders on energy subsidies, as a percentage of GDP included: Indonesia 3%; Thailand 2.6%; Vietnam 2.5%, Malaysia 2.3%, and India 2.3%. India is a primary example where between 2008 and 2012, the country’s diesel demand grew between 6% and 11% annually. Since January 2013, the country has been cutting the subsidies on diesel which has flattened the demand for diesel. The implications of this sudden drop in the global oil price have been negative for the producers whilst positive for importers or consumers.

For the American frackers who borrowed heavily on the expectation of continuing high prices, as well as western oil companies with high-cost projects involving drilling in deep water or in the Arctic, the outlook is negative. This development has prompted the world’s biggest oil companies to announce a series of investment cuts as the current oil price and outlook does not support drilling activity. The International Energy Agency (IEA) projects non-OPEC oil supply to grow by 3.4 million barrels per day to 60 million barrels per day by 2020, at an annual average of 570,000 barrels per day. This is significantly lower than growth of 1 million barrels per day over the past five years and record growth of 1.9 million barrels per day in 2014. Furthermore, oil exporting countries in which governments had become dependent on high oil prices to pay for costly foreign ventures and expensive social programmes have also under the current weak prices found  themselves in deep trouble. The ruble tumbled by 72.3% against the US dollar as Russia’s prospects darkened further whilst Nigeria has been forced to raise interest rates and devalue the Naira. 

However, for oil importing countries the fall in oil prices will have a positive impact on growth. Economists believe that whenever the price of oil exceeds $100 per barrel, global growth struggles. Weak oil prices support economic activity and reduce inflationary, external, and fiscal pressures. Historical estimates suggest that a 30% decline oil prices could be associated with an increase in global GDP by about 0.5%. Furthermore, according to The Economist, a $40 price cut in the oil price shifts an estimated $1.3 trillion from oil producers to consumers. For example, the typical American motorist, who spent $3,000 in 2013 at the pumps, might be $800 a year better off in 2014/15 which is equivalent to an overall 2% pay rise. A country’s average daily petroleum consumption is often a good benchmark of the level of economic activity in that country.

Zimbabwe’s petroleum consumption trend from independence in 1980 to 2013 has been a roller coaster ride with several ups and downs during the period. According to statistics from the Energy Information Administration (EIA), in 1980 the country’s average daily consumption was 12,800 barrels per day with consumption growing since then to a peak of 31,000 barrels per day in 1999. Since 1999 petroleum consumption sharply declined each year to a record post-independence low of 12,500 barrels per day in 2009. With the inception of the multi-currency regime, petroleum consumption has been on the increase, peaking in 2012 at 20,970 barrels per day, before declining to 19,010 in 2013. Given the further economic slowdown in 2014 we expect the average daily petroleum consumption to further decline. Such statistics clearly highlight the extent of the economic meltdown that took place in the country over the last decade and a half. Ghana which was at par with Zimbabwe in terms of petroleum consumption per day in 1980 up to the late 1990s was as at 2013 consuming 66,570 barrels per day and is currently at a gross domestic product (GDP) of US$48.14 billion or $1,770 per capita, according to the World Bank.  Zimbabwe because of the lost decade shrunk to a GDP of $13.49 billion or $860 per capita, according to the World Bank. In 2013 Zimbabwe consumed an average 19,010 barrels of petroleum products per day which translates to 3,022,348.38 litres per day.  Using the same consumption rate for 2014/15, this implies that the 7% to 8% decline in domestic petrol and diesel prices translated to an estimated $132.4 million in savings for petroleum consumers in the country or $9.81 per capita. Such a saving in our opinion is huge, as it is similar to a $132.4 million capital injection into the economy at a time when the economy is in need of a stimulus. From an inflation perspective, this decline in petroleum prices will definitely have a marked impact as transport whose main input is fuel, has a weight of 9.8% in the country’s CPI basket. We therefore believe that the current deflationary trend will persist on the back of the decline in fuel prices going forward. Furthermore, we also believe that given the fact that the US dollar is estimated to be 20% overvalued in Zimbabwe, deflation is actually a good thing for the country as it forces the country’s productive sector to be more efficient. Truth be told, some of the margins that local producers were working with were inherited from the hyperinflationary mindset. The new US dollar reality requires the implementation of global industry best practices across all aspects of business, as failure to do so will result in the ultimate collapse of these industries or businesses. The reduction in petroleum fuel prices also translates to a marginal increase in household real incomes for Zimbabwean consumers which cannot be ignored.

However, looking at the continued company closures and company retrenchments, the benefits of such increments in real income are quickly dissipated by these negative forces. We already expect to see a poor December 2014 and March 2015 reporting season on the Zimbabwe Stock Exchange, which in our opinion will further confirm the extent of the acute decline in overall real disposable incomes and household consumption. The country’s current account position is also expected to improve as a result of the decline in the price of oil on the global market. Zimbabwe’s trade deficit shrank by 14% from US$3.9 billion in 2013 to US$3.3 billion in 2014, on the back of a slowdown imports. Whether this slowdown in imports was a function of increased duties on imports or a slump in aggregate demand or both, is yet to be confirmed. However the strengthening US dollar coupled with subdued international commodity prices are likely to continue having a negative impact on the country’s exports, which may offset the gains from the reduction in fuel importation costs. Government will most probably be the only clear beneficiary of the decline in petroleum prices after it used the decline as an opportunity to increase its excise duty on both petrol and diesel imports. The excise duty on petrol was adjusted from $0.35 to $0.45 per litre, while that for diesel was adjusted from $0.30 to $0.40 per litre. According to our estimates this will translate to a 31.25% (or $110.3 million) increase in fuel excise tax revenue from $353 million per annum to $463.3million per annum, which is huge. Had this tax increase not been effected the benefit of the fall in oil prices to local petroleum consumers or households would have been close to $242.7 million or $18 per capita according to our estimates.However, the question that remains to be answered is that, will the $110 million which government expects to raise from the new excise duty on fuel benefit the overall economy in government coffers or should this $110 million have gone to the petroleum consumers or productive sectors through an additional 10 cent fuel price cut?  To answer this question we look at the likely transmission mechanisms that both sides would use to spend the $110 million wind fall. Government on one side would probably spend a large portion of the funds on civil servant salaries which currently account for 80% of total government expenditure, with the balance going to operational expenses and the servicing of debt. We don’t anticipate that any of the funds will be spent on capital expenditure given the still tight fiscal space. However, because there will be no incremental benefits to civil servants, for example, a salary increment as a result of the upturn in tax revenue, this therefore means that their spend will remain unchanged and impact of the $110 million on the broader economy will be zero.  However if the $110 million was injected into the economy through a further 10 cent decline in fuel prices, this would translate according to our estimates to a $264 per annum saving on fuel costs per every 100 litres of petrol or diesel purchased by local petroleum consumers. This extra disposable income for households would have a positive effect on both consumption and savings which will boost corporate revenues and profits whilst also increasing the country’s deposits base. However given the country’s high affinity for imports, sadly a portion of the increment in disposable incomes will leave the country in the form of increased imports.

Corporations would also benefit from the lower fuel costs as this would significantly improve their cash flow positions especially for businesses where fuel or distribution costs are high. Corporates would also benefit from increased household demand, all of which would result in improved performance and profitability. Government under this scenario could also benefits from increased tax revenue on both consumption and corporate profits. The upside for government will not be as high as the direct tax on fuel, but the momentum created by the fuel price decline on the broader economy will overtime coupled with other progressive policies increase government’s tax revenue.

 In conclusion, lower oil prices if sustained will have a positive impact on global growth especially for oil importing countries such as Zimbabwe. With government total recurrent expenditure now at 92% of total expenditure, the windfall from oil provides government with an opportunity to rebalance its fiscal position and hopefully avoid a possible default in civil servant salaries which we expect to see in the latter part of 2015. For petroleum consumers and households the oil windfall was marginal and we think its impact on the broader economy will not be as pronounced as initially anticipated. Our overall economic outlook for 2015 therefore remains negative, given the continued deterioration of the country’s economic fundamentals.