Fri | Dec 9, 2016

The effects of falling oil prices

Published:Wednesday | December 10, 2014 | 12:00 AM
Dr Andre Haughton
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CRUDE OIL prices have fallen to a record five-year low. Prices have dropped more than 40 per cent since the beginning of the year, moving from a little more than US$115 per barrel, in January, to approximately US$64 per barrel on Tuesday.

This drop in crude oil prices is as a result of increased production and supply of oil, relative to demand, because of less-than-expected global economic performance.

It has been predicted that prices may fall even further, to as low as US$40 per barrel, in 2015, similar to the conditions of the 2008-2009 global financial crisis.

Of the $2 billion of oil Jamaica imports, approximately 36 per cent goes to the Jamaica Public Service, 36 per cent to the transport sector and the rest to aviation and bauxite. One billion dollars of this is from the Petro Caribe Fund, of which, 40 per cent is paid upfront.

Lower oil prices are good for countries that import oil and bad for countries that export. The fall in oil prices will result in a decline in overall prices for Jamaica and other developing/emerging market oil-importing economies.

Lower crude oil prices signify a fall in import prices and a decline in the price of energy, which is a necessary input in most production processes.

The fall will also be reflected in falling gas and electricity prices. For Jamaica, it should represent a fall in overall import bill, which is a significant positive, given the current account goals the country wants to achieve.

The current account deficit to gross domestic product (GDP) ratio of five per cent of GDP is the standard in small-island developing states. Jamaica's is now a little more than 8.4 per cent. The trade deficit is improving marginally, only because the decrease in imports is greater than the decrease in exports, not because of an increase in production.

Even though tourism arrivals is up 3.2 per cent and cruise ship arrivals up by 10 per cent, GDP growth was -0.8 per cent for the quarter ending September, caused by the severe negative impact of drought conditions on agriculture.

Lower crude oil prices mean a lower cost of production, and lower prices of goods and services that depend on oil to be produced.

Lower prices mean households should have more of their disposable incomes to spend on other products. A higher disposable income means increase in aggregate demand, which should be offset by an increase in production, thereby increasing GDP.

What is important here is the rate of pass-through from thee decrease in crude oil prices to consumer and retailer prices. If pass-through is high, consumers will benefit a great deal, and it will contribute more to GDP growth.

However, if pass-through is low, consumers will not receive much of the benefit from the fall in global oil prices and the economy will grow less. The occurrence of the latter is more plausible, giving that prices are normally sticky on the downside.

Retail markets may not relay the fall in input cost to consumers and retail prices. Furthermore, the fall in oil prices have been offset by an increase in agricultural prices due to drought, such that inflation occurs nonetheless in Jamaica. The inflation rate for November was one per cent, the lowest it has been since summer.

Some commentators have been speculating that, along with the benefits, there are some disadvantages of falling oil prices on the global economy. Speculators have posited that there is a strong correlation between falling oil prices and appreciation of the US dollar, relative to other currencies. Countries like Trinidad and Tobago, Venezuela, Russia and Organization of the Petroleum Exporting Countries, where oil represents a significant portion of their exports, may be affected negatively by falling prices.

Falling oil prices are also expected to contribute to deflation in Europe and Japan. These economies have been registering low growth in recent times, despite efforts by their central bank to inject growth via quantitative easing.

A fall in oil prices will contribute more to deflation and quantities easing may artificially inflate asset prices, contributing to possible asset bubbles in these countries in the future.

Oil companies stocks may fall, banks will register a fall in oil-based asset prices, which will have a contagious negative impact on the rest of the global financial sectors. Fall in asset prices tied to oil prices may increase global financial instability.

n Dr AndrÈ Haughton is a lecturer in the Department of Economics on the Mona campus of the University of the West Indies. Follow him on twitter @DrAndreHaughton; or email editorial@gleanerjm.com.