Morningstar's "Perspectives" series features investment insights from selected third-party contributors. Here, Eric Chaney and Manolis Davradakis, AXA IM Research and Investment Strategy team discuss the outlook for oil.
If the collapse of crude oil quotes was temporary, it would only add noise to the global economic landscape and, apart from fuelling volatility, would have no lasting consequences.
Yet, there are reasons to believe the fall is not temporary. As Saudi Arabia has made crystal-clear, its strategy is to preserve global market share, not support market prices. This is rational: back in the early 1980s, Saudi Arabia did the opposite, cutting production to support prices, thereby subsidising its competitors, especially outside OPEC. Only in late 1985 did Saudi Arabia reverse gears and double production to regain market power.
With hindsight, the rise of the real price of oil from 1998 - $18 a barrel in 2014 dollars – to $120 a barrel – again, in today’s money – in 2011 echoed the dramatic increase that followed the Yom Kippur war in 1973 and the Iranian revolution in 1979. Back in the early 1980s, sky-high prices were powerful incentives for exploration, drilling and technical innovation, which, in turn, led to the rise of non-OPEC production. In recent years, lofty prices have made the new technologies of tight oil both profitable and scalable.
According to the International Monetary Fund, 60% of the price fall since July 2014 came from supply side-factors; mostly, but not only, tight oil. But this time, Saudi Arabia and its close allies in the Gulf Cooperation Council have learnt their lesson and have not cut production. They know that lower prices will eventually increase their market share, so that, when prices rise again as a consequence of stronger growth and weaker non-OPEC competition, they would reap the benefit of their bold strategy.
A Welcome Shock for the Global Economy
So let’s assume that the price of crude oil remains between $50 and $70 per barrel in the next two years. In this case, the upside to global GDP growth is really significant. In a recent study, IMF chief economist Olivier Blanchard and his colleague Rabah Arezki consider in their ‘high impact’ scenario, that global GDP could be lifted by as much as 0.8% by 2016.
This may sound strange. After all, rises and falls in energy prices imply transfers of wealth between producers and consumers but should be a zerosum game for the global economy. This may be true in the long run, though not in the shorter term, because oil importing countries have a higher spending propensity than oil producing countries, especially those with large reserves per inhabitant. Even when the oil glut is caused by a recession – and the resulting negative demand shock, it helps the subsequent global recovery, via this asymmetry between consumers and producers.
But when the fall is caused by a supply-side shock of higher production, the impact is even more positive. This is because it increases the purchasing power of consumers in importing countries and, at the same time, reduces input costs for companies, making them more profitable and keener to invest. In the real world, there is nothing like a pure supply side or demand side shock. In their low impact scenario, IMF experts see a 0.4 percentage point increase in global GDP by 2016 compared to the baseline.
Since these estimates include a 0.1 percentage point impact on 2014 growth, which is now water under the bridge, we have assumed an average impact of 0.5 percentage point over the years 2015 and 2016, comprising 0.3 percentage point this year and 0.2 percentage point next. Since, as of today, the oil price fall is larger than assumed by the IMF, our assumption is rather conservative. To some extent, oil markets are providing the global stimulus that many high profile economists, such as Larry Summers, were calling for.
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