Causes and Consequences of Plunge in Oil Prices

While volatility in oil markets will likely persist, prices are expected to remain soft over the next few years. The declining prices present a unique window of opportunity to reform inefficient fossil fuel subsidies everywhere, says a new World Bank estimate.

Posted on 03/6/15
By Admin | Via ViewsWeek
(Photo by KOMUnews, Creative Commons License)
(Photo by KOMUnews, Creative Commons License)

The World Bank says rapid expansion of oil supply from unconventional sources, a significant change in OPEC’s policy stance, and weak global demand are driving the recent plunge in oil prices.


According to the paper — titled “The Great Plunge in Oil Prices: Causes, Consequences, and Policy Responses— these underlying forces are buoyed by a strengthening U.S. dollar and the fact that oil production in the Middle East has not been severely disrupted by ongoing conflict.


Authored by John Baffes, Ayhan Kose, Franziska Ohnsorge, and Marc Stocker, the paper presents a comprehensive analysis of the causes and economic and financial consequences of the oil price decline.


The paper was published as the first in a new series of Policy Research Notes (PRNs), a product of the Office of the World Bank Chief Economist and Senior Vice President for Development Economics.


“The idea behind the Policy Research Note series is to synthesize current research and data, and shed light on issues of contemporary policy concern; as such, these occasional publications should be of value to policymakers and analysts especially in emerging market economies,” a press release quoted Kaushik Basu, World Bank Chief Economist and Senior Vice President, as saying. “This inaugural PRN draws out the many reasons why the current slump in oil prices could persist and exert important effects on the global economy.”


Oil prices fell almost 50 percent between June 2014 and February 2015, possibly marking the end of the commodity price super cycle that began in the early 2000s. The decline has been quite large, but not unprecedented, notes the paper. The latest episode has some significant parallels with the price collapse in 1985-86, which also followed a period of strong supply of unconventional oil and the eventual decision by OPEC to forgo price targeting.


Unconventional and higher-cost oil producers (i.e. US shale, Canadian oil sands and global biofuel production) may well become the new swing, or influential, producers in the oil market. While volatility in oil markets will likely persist, prices are expected to remain soft over the next few years.


The paper estimates that an almost 50 percent decline in oil prices could be associated with a 0.7-0.8 percent increase in global GDP over the medium term.


Low oil prices should exert downward pressures on other commodity prices, especially for natural gas, fertilizers, and food commodities. Cheaper food should benefit a majority of the world’s poor, who are net consumers, the World Bank says. With more than 70 percent of the world’s poor living in oil-importing countries, low oil prices should help in the drive to reduce global poverty. The poor could gain further if falling oil prices allowed expenditures on subsidies to be reallocated to better-targeted pro-poor programs, the paper says.


The impact of lower oil prices for the world economy and developing countries should generally be positive over the medium term, though oil-exporting nations will be hit adversely. Indeed, sharply lower oil prices have dampened investor sentiment about oil-exporting emerging market economies and could add to volatility in financial markets, as we’ve already seen in recent months,” said Basu.


Falling oil prices will affect monetary policies differently depending on whether a country is an oil importer or exporter. For many importers, a side effect has been slowing inflation, which may temporarily ease pressure on central banks and, in some cases, could provide room for continued low or lower interest rates or other accommodative policies in an environment of subdued growth. For exporters, central banks will have to balance the need to support growth against the need to contain inflation and currency pressures.


“While beneficial for the global economy overall, cheap oil could complicate monetary policy making in economies that are already grappling with strong deflationary forces,” the WB press release quoted Ayhan Kose, Director of the World Bank’s Development Prospects Group, as saying.


Fiscal implications of low oil prices will be markedly different for oil importers and oil exporters, but declining oil prices present a unique window of opportunity to reform inefficient fossil fuel subsidies everywhere, the paper says.


To offset the medium-term incentives for increased fuel consumption, while at the same time building fiscal space, policymakers could modify tax policies and increase fuel taxes where appropriate, the paper concludes.


For oil-exporters, the sharp decline in oil prices is also a reminder of the vulnerabilities inherent in a highly concentrated reliance on oil exports and an opportunity to reinvigorate their efforts to diversify. These efforts should focus on encouraging higher value added activities in both manufacturing and services, and on supporting the development of skills and human capital that are important for the expansion of these sectors.


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