Current State of Oil Market and its Impact on the Pakistan Economy

Written By: Dr. Zafar Mahmood

The current spectacular drop in the oil price that began in the summer of 2014 brought the price down to $34 per barrel this month. This is a result of a number of factors that increased supplies and brought down demand. The decrease in demand can be traced back to declining economic growth in China, the recession in Japan, economic downturns in Germany and other parts of Europe, and increased energy efficiency in the United States and Europe. Conversely, the increase in supply was caused by the unanticipated and sharp increase in US and Canadian oil production, the increase in oil production from Russia in recent years and the ability of producers such as Iraq and Libya to maintain output despite their political instability. Added to this is that Organization of the Petroleum Exporting Countries (OPEC) and Russia are determined not to cut production to shore up prices. And now Iran has started pumping crude oil in large quantities for export markets.


The US crude oil stockpiles climbed to the highest level in more than 85 years, giving a bearish outlook to the market. This is a confirmation of a larger physical supply surplus. The slump has slashed earnings of Royal Dutch Shell and Chevron, while Exxon Mobil has reduced its drilling budget to a 10-year low.


Oil is traded globally at a single price, with small adjustments for transportation costs and oil type. Thus, major changes in oil supply or demand in one part of the world change oil prices around the globe. Most of the oil is traded on spot markets between commercial entities with little or no government involvement. Oil prices are quite volatile. This is mainly due to the lag time inherent in the oil industry’s capacity to respond to changes in supply and demand.


The supply of oil is dependent on geological discovery, the legal and tax framework for oil extraction, the cost of extraction, the availability and cost of technology for extraction, and the political situation in oil producing countries. Both domestic political instability in oil producing countries and conflicts with other countries can destabilize the oil price.
Global trends in oil prices since 1987 are worth noting (Figure 1) that reveal the oil price shocks are invariably followed by 2 to 3 years of weak economic growth.


From 1999 till mid-2008, the price of oil rose significantly. It was due to rising oil demand in countries like China and India. In the middle of the Great Recession of 2007–2008, the price of oil underwent a significant decrease after the record peak of US $145 a barrel in July 2008. On December 23, 2008, West Texas Intermediate (WTI) crude oil spot price fell to US $30.28, the lowest since the beginning of (2007-2010) recession. The price sharply rebounded afterwards and rose to US $82 in 2009. On January 31, 2011, it hit $100 for the first time since October 2008 on concerns about the political turmoil in Egypt.


For about three and a half years the price largely remained in the $90–$120 range. In the middle of 2014, price started declining due to a significant increase in oil production in USA, and declining demand in the emerging countries. By January 2015 the price of oil reached below $50. A record dip below $44 was reached in mid-March 2015. The price increased upto $60 in the following months. Oil prices decreased to a six-year low to $36 on December 11, 2015 and to $34.09 on February 5, 2016. Some analysts speculate that it may continue to drop further.


Figure 1: Trends in Crude Oil Price

Interestingly, oil prices are not at a historic low. Oil price cycles are quite normal. Throughout the past century of trade, there have been instances in which the price of oil has swung from high to low and then back up again. Therefore, while low prices will likely to continue in 2016, we are sure that they will eventually follow the normal cycle and rise – though not necessarily back to the historical highs of the last three years.

 

currstate.jpgThus, while various economic trends and geopolitical factors will inevitably impact the global oil market, changes in oil prices should be seen as not unprecedented or unpredictable but as the result of basic economics, driven only by the two mechanisms of supply and demand. However, to understand the factors that affect supply and demand, a deep understanding of geopolitics and the producers of oil around the globe is also necessary.


Proven reserves of crude oil in Pakistan are 247.5 million barrels (1 January 2013). Pakistan’s annual consumption of petroleum products is around 23 million tons. Indigenous crude oil meets only 16% of total requirements while 84% requirements are met through imports in the shape of crude oil and refined petroleum products. Pakistan now follows a market-based policy, in general, for the oil sector. OGRA is maintaining reserves equivalent to 20 days of petroleum demand and is making all efforts to enhance this capacity. Pakistan’s petroleum consumption is about 22.9 million metric tons per annum. Sustained low oil prices will spur shifts in consumer behaviour and industry performance. The overall trend of cheaper oil is likely to have deep implications for the Pakistan economy.


Impact of Declining Oil Prices on Pakistan
Economic Growth: Fall in oil prices are expected to stimulate economic growth in Pakistan. A study analyzing changes in GDP growth shows that if oil prices drop from $84 to $40, it would result in GDP growth of 0.5% to 1.0% for developing countries like Pakistan. Many sectors of the economy would directly benefit from the resulting lower cost of fuel (the agricultural and automotive sectors in particular would benefit).


Current Account Balance: Oil imports account for one third of Pakistan’s total imports. For this reason, the price of oil affects Pakistan a lot. A fall in oil price would drive down the value of its imports. In 2013-14, Pakistan’s petroleum import bill was $15.36 billion, which has come down to $11.86 billion in 2014/15, a 22.8% decline. This would certainly help narrow the current account deficit and increase foreign exchange savings.


The fall in global oil prices may be beneficial for the consumers and economy, but it also has its pitfalls. Directly, it affects the exporters of petroleum producers in the country. Besides petroleum products, Pakistan is also currently exporting condensate crude oil due to lack of its refining capacity in the country. Any fall in oil prices thus negatively impact exports and current account balance.
Many of Pakistan's trade partners and buyers of its exports are net oil exporters. A fall in oil price may impact their economy, and in turn hamper demand for Pakistani products. This would adversely affect the Pakistan economy and companies.
Inflation: A fall in oil prices comes as a windfall to consumers. Low oil prices, along with other factors, have helped reduce inflation. A 10% fall in crude oil prices results in 1% fall in inflation, a study concluded. A decrease in inflation could lead to further cuts in interest rates, increasing credit availability and boosting overall growth prospects since there would be more money available for infrastructural and corporate investment. The decrease in inflation, and the overall improved economic outlook would boost investor sentiment.


Fiscal Impact: The Government of Pakistan makes sure that its budgetary tax collection target fixed for oil sales is met irrespective of crude oil prices. It uses various means and measures (implicit taxation) to meet its revenue targets. As there are no subsidies given on oil sales to any of the users and tax revenue targets are met; therefore, there is no fiscal impact of fall in oil prices. However, a fall in oil prices reduces public sector companies' losses, like PIA and Pakistan Steel Mills, and thus should help narrow fiscal deficit, though marginally.


Rupee Exchange Rate: Exchange rate depends, beside other factors, on the extent of changes in the current account deficit. A high deficit means the country has to sell rupees and buy dollars to pay its bills. This reduces the value of the rupee. A fall in oil import bill is a good omen for the rupee. However, the downside is that the dollar strengthens every time the value of oil falls. This should negate any benefit for our currency from a fall in the current account deficit.

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Foreign Direct Investment: Foreign countries whose economies may be adversely affected by the fall in oil prices may reduce FDI flows to Pakistan. Default in loans given to Russia and shale gas developers in USA could lead to instability in the global banking industry, which could cause investors to err on the side of caution and pull money out of developing countries like Pakistan.


Petroleum Producers: Low global crude oil prices limit incentives for the upstream oil sector. Consequently, it would adversely affect the current exploration policy in the country. Investment in domestic oil production is likely to be negatively affected by low prices leading to lower contribution from this sector to GDP growth. For the past few months, the slide in oil prices has pulled down PSO share price from Rs. 441.75 on June 19, 2014 to Rs. 292 on October 1, 2015, with some revival to Rs. 337 on February 14, 2016 (see Figure 2). Likewise, the share price of OGDCL experienced a free fall from a high of Rs. 280 on August 1, 2014 to Rs. 102 on February 14, 2016 (see Figure 3).

 

Environment: Low oil prices impose a challenge for policymakers to achieve some of their environmental targets. Following the collapse of oil prices, the government may get slow in adjusting natural gas prices. With lower prices in place for oil, natural gas demand may be further affected. The proliferation of private vehicles, which run on diesel and petrol, could significantly increase emissions; unless, changing technologies and tightening environmental controls introduce low oil-intensive growth, significantly reducing energy-intensity levels.


In the end, while Pakistan waits for a more opportune time to make upstream oil projects viable, it should speed up crude procurement to build its strategic reserves. In addition, revive the Iran-Pakistan gas pipeline project and secure long-term contracts commensurating low expected future oil prices.

The writer is a Professor of Economics at School of Social Sciences and Humanities at NUST, Islamabad. This email address is being protected from spambots. You need JavaScript enabled to view it.
 
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