Oil counter shock

Oil prices have entered the sharpest decline since the 2008 financial crisis. The price of Brent crude is down more 35% from summer 2014 levels in euro terms. The causes of this counter shock are not incidental, and it could persist. If crude oil prices were to hold at current levels, the advanced countries of Europe would benefit from a massive transfer of revenue. The Eurozone could get a boost estimated at 0.3 to 0.4 points of GDP in 2015. Its inflation rate is very low anyway, and the drop in energy prices might pull it into a negative territory by early 2015. By nature, counter shock is not deflationary.

Since 2008, China alone has accounted for almost 40% of the increase in world oil demand. In 2014, it surpassed the United States as the world’s largest net oil importer. Clearly, China has the biggest influence on oil prices. Yet the dragon’s appetite has been waning. In 2015, economic growth is not expected to exceed 7%, an enviable performance for most countries, but for China this would be its slowest growth in 25 years. Moreover, Chinese demand for oil products could be even lower than official GDP figures suggest. Electrical power generation is slowing and the sectors hit hardest, such as the mining, steel and cement industries, are also the most voracious in terms of fossil fuels. Lastly, as the Chinese economy diversifies and moves upmarket, it is also gradually becoming more energy efficient.

There has not really been a demand-side shock but rather a sharp dip that is likely to change the price equilibrium for a while. This is especially true since conditions have changed on the supply side. Thanks to shale mining operations, the United States has increased its crude oil and natural gas production by 55% since 2008, and it now produces more in this segment than either Russia or Saudi Arabia. The Saudis have even squeezed prices to defend their market share. The decision not to reduce production quotas at the 27 November OPEC meeting marked a turning point. Brent crude oil prices plunged below the USD70 a barrel, the point at which nonconventional hydrocarbon production in North America is said to be less profitable. Yet this threshold varies widely from one region to the next. A shift in the price equilibrium would mainly trigger a domestic substitution effect without affecting overall production volumes. To be a real game changer, the counter shock would have to become more protracted and larger in scope. All in all, we see little reason to expect crude oil prices to pick up, at least not before the next OPEC meeting scheduled for June 2015.

Mario Draghi, president of the European Central Bank (ECB), recently said that the decline in oil prices was “unambiguously positive” for the eurozone, above all because of its direct impact on reducing energy bills. In 2013, the eurozone-18 paid out EUR 337 bn to cover their imported oil bill. In Q4 2014, they have already saved the equivalent of 0.2 points of GDP. From a 1-year horizon, the various macro-econometric models converge to estimate that a 35% decline in oil prices would boost activity in Europe by about +0.3 to +0.4 points of GDP. The mechanics are simple: in the short term, the shock lowers energy prices (petrol, heating fuel, etc.) and the prices of certain services (transport, etc.). Given the rigidity of nominal wages, household purchasing power increases as a result, which stimulates consumption and in turn activity. For companies, the decline in oil prices results in milder input prices and boosts margins. This has a positive impact on both investment and employment. For the so-called “realistic” models, which take into account interactions at the international level, the impact tends to be amplified. The propensity to consume income tends to be higher on average in the oil-consuming countries than it is in the oil-producing ones. The transfer of wealth implied by the change in the terms of trade is not a zero-sum game. France, for example, benefits from an increase in world demand for French products and higher exports. The French economy’s response however, seems to be more limited, which can be explained by two factors. First, it is a service- oriented economy (80% of the total value added of sectors). Second, given the size of its nuclear sector, oil accounts for a relatively small share of total energy consumption. The main countries that stand to gain are above all Portugal and Spain in the south and Ireland and the Netherlands in the north.

The energy component accounts for 9% of Eurostat’s harmonised consumer price index. Moreover, this component is comprised primarily of taxes. As a result, it is much less sensitive to fluctuations in crude oil prices. The direct impact of a 35% decline in oil prices is around -0.4 points of inflation. In the eurozone, where prices are already barely rising, there is a high probability that inflation will near zero in the coming month.

Does this mean there is a risk of deflation? Considering that activity is stimulated at the same time, the answer is no. The Eurozone economy is growing below potential and suffers for a shortfall of demand. Compared to Japan, it is more likely to respond to a shock such as lower oil prices or the euro’s depreciation. Looking beyond the somewhat erratic fluctuations of energy and food prices, core inflation is above all sensitive to the output gap, which is supposed to start to narrow in 2015.