A Complex Story: Global Impact of Low Oil Prices

The fall in oil prices has been one of the most important macro-economic events recently. While it has certainly meant lower fuel bills for consumers,  it has also drastically reduced the revenues of oil-exporting countries. We will have a look at the impact of the drop in oil prices on the 3 leading oil-exporting countries: Saudi Arabia, Russia and Iran, as well as on oil-importing countries – the US, China and India. (For related reading, see article: What Determines Oil Prices?)

The Saudi Arabian government is heavily dependent on oil revenues, with almost 90% of the government’s revenues coming from oil. The recent fall in oil prices is likely to result in a higher government deficit and may result in lower government spending. This is bound to have a significant impact on job creation within the country, as most of the private sector jobs that are available are based on government contracts. The kingdom also has vast social-sector spending commitments that it increased after the Arab Spring. Though in the short term the reduction in revenues due to low oil prices won't be an issue due to the fact that the Saudis can dip into their US$700 billion sovereign wealth fund for revenues, in the longer term Saudi Arabia needs around US $104 billion to balance its budget. But even after the drastic fall in oil prices, the Saudis haven’t cut their oil production in order to push oil prices upward. The reasons for not doing so are claimed to be entirely political in nature, as the lower prices are likely to hurt shale oil production in the US, which would be a long term positive for the Saudis.

Russia has by far been one of the countries that have been most adversely affected by the recent plunge in oil prices. Its oil revenues, which constitute more than half of its budget revenues and approximately 70% of its export revenues, have dropped significantly, with an estimated US $2 billion loss in revenue for Russia per dollar fall in oil prices. Russia's currency has as a result collapsed, which forced its central bank to raise interest rates and sell its foreign currency reserves to support the Ruble. The ensuing chaos has led to a downgrade of Russia’s sovereign bonds to junk by credit rating agencies and resulted in capital flight away from the country, all of which is likely to result in a contraction in the Russian GDP. The Russians need oil prices to be above US $105 a barrel to balance Russia's budget; market conditions in which the prices fall below this will either cause the Russian government to run deficits or force it to cut down on its other development programs. (For related reading, see article: Sanctions And Oil Prices Bring The Russian Economy Near Collapse.)

Already reeling under heavy economic sanctions imposed by Western nations, which reduced its oil exports by more than half, Iran now has to face the double whammy of lower oil prices. Iran depends on oil for slightly less than half of its total revenues and more than 80% of its export revenues, so the recent fall has already led to lower figures in its budget estimates. Though in the short term the impact on Iran's economy will be cushioned by the government's use of a fund that was set up to counter lower oil prices, in the longer run it is estimated that Iran needs oil prices to be above US $130 to balance its budget. The nuclear deal with Iran will be positive for Iran’s economy, but it would also signal that Iran's oil would be added to the present supply of oil on the market, which may put further downward pressure on oil prices.

On the face of it, although the US seems to be a huge beneficiary of lower oil prices, deeper analysis shows the situation to be a bit more complex. Though the US is the second largest importer of oil, it is also the second largest producer of oil and there has been a significant increase in US oil production over the past 5 years, mainly due to the use of newer technologies such as fracking. While lower oil prices will benefit consumers in terms of increased savings that are likely to increase consumption and result in an uptick in the GDP, they are also likely to hurt  U.S. shale oil producers in the long term -- who according to estimates need oil prices to be above US $60 to break-even -- and lead to lower associated investment. Lower oil prices will also negatively affect the profitability of US energy companies such as Exxon, Chevron etc. (To read more about the shale resources in North America, see article: Guide To Oil And Gas Plays In North America: Shale.)

Although China is on its way to becoming the largest importer of oil, and depends on oil imports for 60% of its consumption, the benefits of falling oil prices to China have not been as extensive as principally expected due to the government raising taxes on oil products.  There have also been concerns about lower growth prospects and a slowdown in real estate, where a majority of household wealth is invested, and this has resulted in increased household savings. Also, one of the reasons for lower oil prices is the lower demand from China, where fears of deflation led to the central bank reducing the amount of reserves that banks are required to hold. The Chinese government has also utilized this recent fall in oil prices to increase its strategic oil reserves. Thus, the lower prices will certainly improve China’s current account surplus and lower costs for businesses, but are not likely to have much of an impact on the Chinese economy due to other deeper structural problems in the economy.

The fall in oil prices should lead to a significant improvement in Japan’s trade deficit, given the fact that Japan imports most of the oil it consumes. While the price dip should significantly raise corporate profits and boost household income, however, this has been offset to some extent by the depreciation of the Yen relative to the Dollar. Further, lower oil prices are likely to decrease inflation, which is likely to make the Bank of Japan’s aim of 2% inflation more difficult to achieve. Japan's power sector, on the other hand, is likely to benefit, since it has been using oil power plants to make up for the lost capacity due to the closure of nuclear reactors and their inability to pass on the higher costs to consumers. (For related reading, see article: Japan's Strategy To Fix Its Deflation Problem.)

Although lower oil prices are always welcomed by consumers, the global impact of the fall in oil prices is much more difficult to interpret, since many countries depend on oil as a major revenue source and lower prices hurt their economy. Lower oil prices could also signify a weak global economy, which could more than outweigh the benefits of lower oil prices.