The Appeal of Higher Oil Prices

Post-Doc and Teaching Fellow at Alzahra University
The Appeal of Higher Oil PricesThe Appeal of Higher Oil Prices

The world is facing an undeniably high level of uncertainty and oil price is just one of the unknown variables that impacts the future global outlook.

Investors and analysts are increasingly admitting that they have no idea what’s in store. The same holds true for policymakers dealing with oil price.

While the Iranian government has projected a $35-40 crude oil in 2016, Saudi Arabia sees the crude oil at $29 per barrel and Russia at $50.  

Among dozens of reports predicting the oil glut bringing down oil prices to as low as $10 per barrel, oil price witnessed an 8% surge on Thursday. With declining oil revenues drilling holes in their budgets, Russia and Saudi Arabia now mention their willingness to cut 2 million barrels a day off the market.

As Russia is willing to coordinate with the Organization of Petroleum Exporting Countries, the markets will eagerly wait for this month's OPEC meeting that will hopefully not end in acrimony like the previous one.

This is important for the world economy; if OPEC members agree with Russia on the supply target, there would be less uncertainty and more stability. This is literally what investors are craving for.

One might ask why the world needs higher oil prices? At least for oil importing countries lower prices should be preferable, but it does not appear to be so.

Basically, oil is a factor of production and lower oil prices means lower cost of production and more supply of goods in general. This, in turn, leads to lower prices of commodities and services.  

Assuming services are not tradable, the lower commodity prices project fear for international trade and governments struggling to materialize their inflation targets.  Lower domestic price of services reduces the income for service providers and contributes to weaker growth.

This is because consumption of services and tradable goods will not increase as much to compensate the change in prices. Low commodity prices have made International Monetary Fund to revise its prediction for global economic outlook.

On the other hand, for oil exporters, this leads to loss of oil revenues and ballooning budget deficits that substantially lower their purchasing power.

This will translate into lower global demand that is already spotty due to China’s slowdown. The reduction in global demand caused by lower oil prices and decreasing profitability of firms active in oil-exporting markets is worrisome.

While the oil price slump creates fear and panic in many markets in the short run, changes in utility prices also affect the mood of consumers. Consumption habits don’t change dramatically, as consumers adapt to their level of income and not the price of commodities.

Moreover, because of duties on gasoline and price rigidities, the effect of lower oil prices might not lead to substantially lower utility prices needed to increase consumption. And lower utility prices don’t trigger more investment when the economy is shaky.

Many investors track the price of crude oil because oil is the world’s most actively traded commodity and its price will essentially affect all commodities through the cost of transport. With many prices of commodities at record low and stock markets already into bear-market territory, higher oil prices are what the markets need these days.

With higher oil prices, commodity producers will get higher prices for their products. For banks and investors, this means lower risk of defaults and higher profits.

Mind you, analysts at Jefferies have predicted that a sustained crunch in commodities could wipe 20% off European and British banks' profits.  This is because with lower prices of commodities, firms are less able to repay their loans. Even if firms have raised money through bonds, the higher risk of their default will make the global economy sluggish.

Some countries are still recovering from the 2007-09 crises and their leaders are tired of trying to stop things from getting worse and having little control over their economies. Hence, they are willing to do what it takes to improve the state of world and higher oil prices definitely help to reduce the risk and uncertainty, and boost the aggregate demand.