The fall in the world oil price and its implications for the UK economy

John Fender, Professor of Macroeconomics, comments in The Birmingham Brief:

The world oil price is now about $30 a barrel. In the summer of 2014, it was well over $100 a barrel. This decline was almost completely unpredicted, but it now seems likely that with,inter alia, a large quantity of Iranian oil about to hit the world market, the price will stay low for some time to come.

What are the implications of this price decline for the UK economy? A simplistic view is that whether a price fall is beneficial or harmful depends on whether one is a buyer or a seller, and as the UK is now a net importer of oil, it should benefit. However, this view needs qualification. The North Sea oil industry has been badly hit by the price fall, so we can expect plenty of pain there. But for the many sectors of the economy which use oil as an input the effect is favourable. As far as the macroeconomy is concerned, consumer price inflation can be expected to stay extremely low and unlikely to exceed yesterday’s figure of 0.2 per cent by much for some time. The overall effect on economic activity should be positive, as firms experience lower fuel costs and consumers’ disposable incomes, and hence spending, rise. We can expect the current modest rate of economic recovery to continue, with unemployment falling.

The effect on the rest of the world will be varied. Large oil exporters – countries such as Russia and Venezuela – will suffer considerably, but much of the rest of the world, including Europe, which is a heavy oil importer, will benefit. A rise in economic activity in Europe should increase demand for UK exports and hence provide a further stimulus to UK economic activity.

Given the extremely low rate of price inflation, the Bank of England is likely to keep interest rates at their current low level for the remainder of 2016.

The fall in the oil price has led oil companies worldwide to slash their capital expenditure, which means they will have less capacity to produce oil in the future. So a fall in oil production in due course seems inevitable, as does an increase in the oil price. But it is impossible to predict when such an increase will occur. If forced to make a prediction, I would guess that the world oil price may start to rise significantly in about a year’s time. Assuming the economy has continued to grow at a reasonable pace in 2016, we might also see increasing wage costs as a consequence; so inflation might well pick up in early 2017 and we might see an interest rate increase then. The increase may come earlier if the Bank of England predicts a rise in inflation above its target if policy is unchanged.

However, there are too many imponderables for predictions to be better than speculative. What will happen to Chinese economic growth in 2016? What is going to happen in the Middle East? What will Russia do? What will happen in the US presidential election? What will the outcome of the UK Brexit referendum be? And so forth. One worrying scenario concerns the many oil companies around the world which are heavily in debt. Undoubtedly there will be defaults and bankruptcies. This will put pressure on lenders, including many banks. Another financial crisis is not inevitable but it is by no means impossible.

So although the oil price decrease is probably good news overall for the UK (and world) economy, there are some major uncertainties and risks which it would be foolhardy to ignore.