Celebrate cheap oil

One of the great paradoxes of 2014 was the apparent mismatch between falling oil prices and military conflict in strategic regions. Normally fighting in the Middle East and the Ukraine would be expected to push up oil prices. Only this year the price has fallen sharply since June. According to the US Energy Information Administration the price of a barrel of West Texas Intermediate crude fell from almost $108 per barrel in mid-June to below $56 in mid-December.

It would be a mistake to conclude from this discrepancy that geopolitical uncertainty has no effect on the oil price. A more accurate conclusion would be that the forces pushing the price of oil down were greater than those pulling it up. In other words the balance between supply and demand has tilted in favour of the former.

Two key factors on the supply side helped push down oil prices. Together they constitute what the Economist dubbed sheikhs vs shale. The rising production of shale oil, particularly in America, as well as Saudi Arabia’s decision to maintain its crude output both played an important role.

But it would be wrong to underestimate the role of sluggish demand growth, particularly in China and Europe, in reinforcing the downward trend. Although demand for oil is still heading upwards the rate of growth is being called into question. The slowdown in China’s economy in particular will weaken what has been one of the main upward drivers of the oil price for many years.

Of course some of this is subject to change. A low oil price weakens the impetus to invest in the industry and so could lead to curbs on supply growth in the future. Exploration and development that was once profitable may no longer be economical at the lower price.

However, there is a more fundamental lesson that should be learnt from this whole saga. It is not the oil price that drives the state of the global economy. On the contrary, the state of the world economy plays a key role in determining the oil price.

Too many commentators are ready to pin a large part of the world’s economic fortunes on the price of crude. From their perspective low prices boost growth while high prices carry the risk of inflation.

It would be more accurate to see things the other way round. A dynamic global economy should enjoy rising energy demand alongside strong economic growth. It should also show strongly rising supply as investors put their money into developing new sources and better technology. Ideally rising production should outrun increasing consumption and so help to keep prices low.

It is true that over time different sources of energy could come to surpass oil in importance. Indeed coal, natural gas, nuclear and renewables already play a big role in the energy mix. News of the largest ship the world has ever seen, designed for use as a processing platform for natural gas, is a positive sign of determination to develop new supplies.

Nevertheless oil is still a key energy resource and it likely to remain so for some time to come. The rapid development of new sources of supply and better extraction technology should be widely welcomed.

I would like to wish my readers a Merry Christmas and a Happy New Year.

This blog post was first published on Fundweb yesterday.