Written By: Dr. Zafar Mahmood
Like prices of other commodities, the price of crude oil experiences wide price swings in times of shortage or oversupply. Unlike many other commodities, the crude oil price cycle may extend over several years responding to changes in global demand and supply. Global oil prices have fallen sharply over the past seven months, leading to significant revenue shortfalls in many oil exporting nations. On the other hand, consumers in oil importing countries, including Pakistan, are now paying less.
Between 2010 and mid-2014, world oil prices remained fairly stable at around $115 a barrel. Among the reasons attributed to this trend was the higher consumption pattern by major oil importing nations like China and India. Also, the geopolitical tensions in nations like Iraq and Libya too kept the prices high. As oil producing nations could not keep up with the world demand, as a result the prices rose. But since June 2014 prices have more than halved. Brent crude oil has now dipped below $50 a barrel for the first time since May 2009. US crude, which is lighter and sweeter, has also fallen below $50 a barrel.
The reasons for plummeting oil prices are twofold – weak demand in many countries of Asia and Europe due to weak economic growth, coupled with surging US oil production due to shale gas and oil. Shale is a natural gas found in shale formations – a type of rock in the earth's crust. It is being considered as the new source of natural gas as other sources are fast depleting. US is at the forefront of exploring and producing shale gas. It accounted for 39% of its natural gas production in 2012.
Added to this is the fact that the oil cartel OPEC is determined not to cut production as a way to prop up prices. OPEC members are losing large export earnings but do not want to cut their production at this stage. They are increasingly using their accumulated future generations’ fund to bridge the current account and fiscal deficits.
Russia is one of the world's largest oil producers. Its economy heavily depends on energy revenues, with oil and gas accounts for about 70% of export earnings. Russia is expected to lose about $2 billion in revenues for every dollar fall in the oil price. Consequently, its economy is likely to shrink by at least 0.7% in 2015 if oil prices do not recover. Russian Government has predicted that its economy will sink into recession. Despite this, Russia has confirmed it will not cut production to shore up oil prices. This is because with a cut in oil production, Russia expects that its importing countries will increase their production, which means a loss of its niche markets.
Saudi Arabia, the world's largest oil exporter and OPEC's most influential member, could support global oil prices by cutting back its own production, but there is little sign it wants to do this. Two reasons: first, to try to instill some discipline among OPEC members and second to put pressure on USA's promising shale oil and gas industry, as OPEC now recognizes the challenge of US production. Although Saudi Arabia needs oil prices to be around $85 in the longer term to balance its budget, it has large reserve fund of about $700 bn, so it can bear lower prices for some time. Like Russia, OPEC believes that lower prices would force some higher cost producers to shut down their production so that it can pick market share in the longer run. OPEC has also learned from its history. In the 1980s, OPEC cut its production significantly in order to boost prices, but it had little effect, although it badly affected the member countries’ economies. So this time OPEC is cautious and has shown unwillingness to cut its production level.
The growth of oil production in North America, particularly in USA, has been staggering. US oil production levels were at their highest levels in almost 30 years. It has been this growth in US energy production, where gas and oil is extracted from shale formations using hydraulic fracturing that has been one of the main drivers of lower oil prices. Despite many US shale oil companies have far higher costs, $60 to $70, than conventional rivals; many of them need to carry on pumping to generate sufficient revenues to pay off debts and other costs. With Europe's weakening economies currently characterized by low inflation and weak growth, any benefits of lower oil prices would be welcomed by stressed governments. China, which is set to become the largest net importer of oil, should gain from falling prices. However, lower oil prices won't fully offset the far wider effects of a slowing economy.
Japan imports nearly all of the oil it uses. But lower prices are a mixed blessing as high energy prices had helped to push inflation higher, which has been a key part of Japanese government’s growth strategy to combat deflation. A 10% fall in oil prices should lead to a 0.1% increase in economic output, some experts predict. In general, consumers benefit through lower energy prices, but eventually, low oil prices do erode the conditions that brought them about. Pakistan’s imports of petroleum and its products account for about 33 percent of its total imports. Falling oil prices are expected to ease its current account deficit, which will strengthen Pak Rupee. With low oil price, industrial production cost will go down hence our exports may become internationally competitive. At the same time, revenue from petroleum-related levies will fall because Pakistan imposes ad valorem taxes instead of specific duties. To recover falling tax revenue, government has announced to impose additional 5% sales tax on petroleum products. Lower oil prices are helping government to contain inflation rate. Current inflation rate is 4.3% (December 2014), which is likely to further go down; both consumers and government are cheering. Pakistan’s projected recoverable shale gas is estimated at 105 trillion cubic feet of recoverable gas and 9.1 billion barrels of shale oil reserves. However, its production costs in Pakistan will be considerably high due to the advanced technological requirements and relatively unknown terrain. Pakistan needs a policy to attract technology for its exploration.
The steep fall in crude prices is de facto, a fiscal stimulus. It is likely to boost growth and employment. Consequently, unemployment and poverty will fall. However, fall in earnings of oil exporting countries, especially in the Arabian Gulf region, is likely to reduce inflow of FDI to Pakistan. Default in loans given to shale gas developers in USA could affect the global banking industry which in turn could cause imbalances, and hence a fall in capital inflow from these sources to Pakistan.
All in all, the biggest fall in oil prices since the 2008 global recession is shifting wealth and power from oil producing states to oil importing states. Surging U.S. and other Organization for Economic Cooperation and Development (OECD) shale supply, weakening Asian and European demand and a stronger dollar has pushed oil to a five-and-half-year low, with a price below $40 a barrel not out of sight.
Even as cheaper fuel stimulates the global economy, it could aggravate political tension by squeezing government revenue and social benefits. Pakistan government is quick enough to announce 5 percent additional sales tax on petroleum to account for the falling revenue on this account. Political tensions in some of the oil exporting countries may increase if the fall in oil prices persists.
Pakistan needs to carefully manage falling oil imports bill. With lower oil prices if demand goes up proportionately then import bill will not go down. Pakistan’s domestic crude oil production may fall if marginal producers become uncompetitive. Thus, government needs to make all efforts not only to stabilize the currency but properly manage demand and domestic production, too.