Understanding The Plunge In Oil Prices: Sources And Implications

By The World Bank

• The decline in oil prices since mid-2014 has been significant but not unprecedented.

• Supply related factors, including a shift in OPEC policy, have played a dominant role.

• Lower oil prices will contribute to global growth and temporarily reduce global inflation in 2015 and will generate significant real income shifts from oil-exporting to oil-importing countries.

• Financial problems in large oil-exporting countries could lead adverse contagion effects on other emerging and frontier markets.

• Declining oil prices present a significant opportunity to reform energy taxes and fuel subsidies, and reinvigorate reforms to diversify oil-reliant exporting economies

Drop in oil prices since mid-2014: sharp but not unprecedented. Oil prices dropped sharply between June and December 2014, bringing to an end a four-year period of relative price stability. The size and speed of the decline has been significant but not unprecedented (Figure 1). Over the last 30 years, five episodes of price declines in excess of 30 percent were observed, coinciding with coinciding with major changes in the global economy and oil markets.

Key drivers: ample oil supply, weak demand, shifting OPEC policy. There have been a number of factors behind the recent plunge in oil prices: several years of upward surprises in oil supply and downward surprises in demand, unwinding of some geopolitical risks, changing OPEC policy objectives, and appreciation of the U.S. dollar (Figure 2). Supply-related factors, and in particular the failure of OPEC to agree on supply cuts in November despite sharply lower prices, have played a critical role in recent developments.

Global growth: a net positive effect. If sustained, lower oil prices will contribute to global growth and lead to sizeable real income shifts to oil importers from oil exporters. Estimates suggest that a 30 percent oil price decline could increase global GDP by up to 0.5 percent. However, both cyclical and structural factors might affect the impact of oil price drop on growth in 2015-16.

Global inflation: temporarily lower. A 30 percent decline in oil prices is expected to reduce global inflation by about 0.4-0.9 percentage points in 2015. However, in the course of 2016, inflation would return to levels prior to the plunge in oil prices (Figure 3). The impact across countries will vary significantly, reflecting the importance of oil in consumer baskets, exchange rate developments, stance of monetary policy, the extent of fuel subsidies and other price regulations.

Real income shifts: from oil-exporting to oil-importing economies. Oil price declines generate changes in real income benefiting oil-importers and hurting oil-exporters. A 10 percent decrease in oil prices could raise growth in oil-importing economies by some 0.1–0.5 percentage points, depending on the share of oil imports in GDP. Their fiscal and current accounts could also see substantial improvements. On the other hand, it would affect oil-exporting countries adversely. Empirical estimates suggest that growth in some oil-exporting countries could contract by 0.8–2.5 percentage points in the year following a 10 percent decline in the annual average oil price. The slowdown would compound fiscal revenue losses in these countries as fiscal break-even prices exceed current oil prices for most oil exporters. In some countries, the fiscal pressures can partly be mitigated by large sovereign wealth fund or reserve assets.

Economic and financial strains on exporters: spillover risks. Low oil prices have already led investors to reassess growth prospects of oil-exporting countries. This has contributed to capital outflows, reserve losses, sharp depreciations, or rising sovereign CDS spreads in many oil exporting countries, including in Russia, Venezuela, Colombia, Nigeria, and Angola. Financial strains could imply adverse spillover effects for partner economies, through trade and financial linkages, including remittance flows.

Fiscal policy: opportunities to reform subsidies. Declining oil prices present an opportunity to reform energy taxes and fuel subsidies, which are substantial in several developing countries, and reinvigorate reforms to diversify oil-reliant economies. Egypt, India, Indonesia, Iran, and Malaysia already implemented subsidy reforms in 2013 and 2014. Fiscal resources released by lower fuel subsidies could either be saved to rebuild fiscal space lost after the global financial crisis or reallocated towards better-targeted programs to assist poor households, and critical infrastructure and human capital investments.

Monetary policy: focus on inflation expectations. The impact of lower oil prices on inflation is expected to be mostly temporary. In most cases, central banks would not need to respond to a temporary fall in inflation—unless there is a risk that inflation expectations become de-anchored. In some parts of Europe several months of outright deflation could lead to such outcome. In oil exporting countries with flexible exchange rates, central banks will have to balance the need to support growth against the need to maintain stable inflation and investor confidence in the currency.

Structural policies: reduce reliance on fossil fuels. To offset the incentives for increased oil consumption as oil prices decline, policymakers could modify tax policies on the use of energy, especially in countries where fuel taxes are low. For oil-exporters, the sharp decline in oil prices is also a reminder of the vulnerabilities inherent in a highly concentrated reliance on oil exports and an opportunity to reinvigorate their efforts to diversify.

Read the full report from The World Bank: Understanding the Plunge in Oil Prices: Sources and Implications –
Global Economic Prospects, January 2015

Courtesy of The World Bank, © 2015 The World Bank Group, All Rights Reserved