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Link between oil prices and world growth

oil prices downBack on deck after a good two week break. One issue that has been prevalent has been the drop in oil prices. The benchmark Brent crude oil price has fallen from US$115.65 on 19th June 2014 to US$56.42 today (4th January 2015) – that is a 51.2% drop. Why have prices dropped so much in such a short period of time?

The main reason for this is the increase in fracking where energy companies go deep into the ground and blast the shale rock with a mixture of water and chemicals which releases oil and gas to the surface. This technique has been particularly prevalent in US where production has increased from 5 million b/d in 2008 to nearly 9 million today. Ultimately the price has dropped because supply has outstripped demand. Of world production OPEC produces 30.3 million b/d and the rest of the world 61.8 million b/d. With this over supply you would expect OPEC countries to agree to reduce the volume of oil they pump everyday. However, according to Brian Gaynor in the NZ Herald, they are unwilling to reduce production for various reasons:

1. Most member countries are heavily dependent on oil export revenue
2. They have to meet interest costs on large government deficits
3. They believe that lower oil prices in the short term will discourage further investment in fracking and ultimately lead to higher long-term price for conventional oil.

Oil prices and world growth

The link between oil prices and the economic conditions of the global economy are well documented.

Low oil prices = booms periods in the global economy from 1948-1973 and 1993-2007
High oil prices = recessions – 1974-75, 1981-82, 1990-91, 2008-09

Low prices do stimulate growth – it means more spending power for consumers and it cuts cost for business. However the lower price will affect countries like Russia, Venezuela and Iran as they can only balance their books if the oil price is at US$100 a barrel or more. The US would be particularly affected by this lower oil price as much of the investment in fracking has been financed by high yielding but risky junk bonds. As the credit risk becomes greater with lower oil prices this could lead to sales by investors which would lead to illiquidity. According to The Observer newspaper “fracking could become the new sub-prime”.

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