The plunge in oil is all the more fascinating because, over the first half of 2014, the concern was that prices would balloon due to tensions in the Middle East, specifically in Iraq. Yet the feared supply disruptions didn’t materialise. There is also the shale oil story. Over 2014, the US became the world’s biggest oil producer, which is still a fact that surprises people. A continued expansion of shale production in the United States, driven by the deployment of new extraction technologies, has altered the supply and demand dynamics of the market.
Much attention has been paid to the effect this has had on individual economies. Russia has been hit hard by oil price declines, for example. Aside from the impact on the oil and gas sector, for a net importer of oil like the UK, the effect has been largely positive.
But it also has big implications for businesses, both large and small. It’s important that the oil price slump has not been driven by falling global demand. If oil prices had fallen because demand had tumbled off a cliff, it would be a really negative factor for companies and the economy. But with the UK recovery solid through the last year, and the global economy growing in line with its longer-term average, to most British companies, a supply-led decline in oil prices is extremely helpful.
The most visible aspect of cheaper oil is the price of petrol at the pump. That evidently came down sharply, and has been a particular boon for firms with large transport costs. But lower oil prices also feed through into a number of other areas. Energy bills, for example, represent a sizeable proportion of most companies’ overheads. Given falling input costs, businesses may be able to pass on some of these savings to consumers, thereby making their products or services more competitive. Our gut feeling is that we’ll continue to see a degree of energy-related disinflation throughout the economy.
Lower oil prices, by leaving more money in the pockets of consumers and businesses, should lead to greater consumer and business spending too, thereby putting upward pressure on economic growth.
And by weighing on inflation more generally, the fall in oil prices has also pushed back the expected timing of the Bank of England’s first interest rate rise. The consumer price index measure of inflation was flat in February (meaning prices were the same as the year before).
Concerned about a pernicious low-flation or deflationary cycle – where consumers and businesses begin to expect that inflation will be low for a longer period of time, thereby delaying their spending and hitting growth – the sensible thing for the Bank to do is put monetary policy on hold until it’s reasonably confident that lower inflation expectations aren’t going to be embedded. While keeping interest rates lower for longer will arguably increase inflation pressures over the medium term, a happy adjunct should be lower financing costs for businesses.
Philip Shaw is chief economist at Investec.