The economic consequences of global oil deflation

A new wildcard has just been introduced into an already increasingly unstable global economy: a growing world glut of oil and consequent oil price deflation.

Jack Rasmus

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SINCE June 2014, the price of high-grade (ICE Brent) crude oil has fallen more than 40%, declining from around $115 a barrel in January 2014 to just $67 a barrel at the end of November. That's the lowest since the bottom of the 2009 recession. The price decline has not only been deeper than expected in a normal cyclical correction, but also appears to be more than just a temporary event. Some predict global oil prices will fall below $60 a barrel in 2015, and could potentially fall as low as the $40 level that occurred during the 2008-09 recession.

What effect a deep and sustained oil price deflation will have on the global economy - which is already drifting towards stagnation and, simultaneously, rising financial instability - is hardly being discussed at all in the Western business press. Instead, oil deflation is reported as a positive economic development, both for the advanced economies (AEs) and for emerging market economies (EMEs), as well as the global economy in general.

Economists, the business press and governments in the advanced economies are all giving a 'positive spin' to falling oil prices, claiming it will mean lower costs to both businesses and consumers in the AEs. Lower oil prices mean lower gasoline prices and thus more for consumer households to spend elsewhere. Lower oil costs will stimulate business investment and spending, it is argued, and thus also boost economic growth. But this simplistic view may prove incorrect, not only for the AEs but for emerging market economies in particular and for the global economy in general. The combined negative effects of deep and sustained oil price deflation may well outweigh its positive effects.

There are at least three major potential impacts on global economic instability that will likely follow in the wake of global oil price deflation, some of which have already begun to appear.

First, a more rapid appreciation of the US dollar, and the corresponding relative decline in the currencies of a number of emerging market economies, in particular those dependent on commodity exports and especially those for which oil exports make up a significant percentage of total exports. There is a long, historical and documented relationship between falling oil prices and a rising US dollar. So global oil deflation means a rising US dollar.

A second destabilising impact from falling oil prices will be to contribute towards general deflation in Europe and Japan. Economies there have already entered recession. Despite trillions of dollars in liquidity injections by their central banks in recent months, inflation levels have still fallen to zero or less. Oil deflation will add significantly to a general deflationary drift in both Europe and Japan. That in turn will likely lead to even more liquidity injections by their central banks, in the form of more quantitative easing (QE), further feeding stock market and bond asset bubbles.

Thirdly, a decline in financial assets tied to oil could increase the tendency towards global financial instability. Oil deflation may lead to widespread bankruptcies and defaults for various non-financial companies, which will in turn precipitate financial instability events in banks tied to those companies. The collapse of financial assets associated with oil could also have a further 'chain effect' on other forms of financial assets, thus spreading the financial instability to other credit markets.

The positive impacts of falling oil prices on economies, including the US, are generally overrated. Oil price declines may not have as much positive impact on consumer spending and business investment as many in the AEs now assume. The total net effect on the global economy will therefore likely prove more negative than positive.

Oil deflation's potential impact on EMEs

The continued collapse of world oil prices since June has already been having a devastating effect on emerging market economies, especially those dependent on commodity exports - like Brazil, Chile, Argentina and South Africa, and even Australia and a number of economies in Southeast Asia. Oil deflation has had an even more severe impact on those EMEs highly dependent on oil exports as a large percentage of their commodities mix - like Venezuela, Russia and Nigeria.

The initial transmission mechanism by which global oil deflation negatively impacts EMEs is falling currency exchange rates. Oil price deflation is generally associated with a corresponding rise in value of the US  dollar  relative  to  other  currencies. A rising dollar in turn means falling currency values for other countries.

Since the collapse of global oil prices began in earnest last June, the Russian ruble has fallen approximately 38% and the Venezuelan currency, the bolivar, by around 45%. Nigeria's currency, the naira, has declined 12% since just mid-October. Even for a developed oil-exporting country like Norway, its krone has fallen 17%. After having remained stable for several years, the US dollar clearly began to rise last June, as global oil prices commenced their freefall that same month. So falling oil prices drive the dollar up and in turn depress EME currencies, especially the currencies of oil-exporting economies. And the more dependent the economy is on oil exports, the greater the EME currency decline.

In other words, it's not sanctions on Russia by the West that are responsible for the lion's share of the ruble's recent decline. Nor is it Venezuelan domestic economic policies that are contributing most to the decline in the value of the Venezuelan bolivar. It is the collapse of global oil prices that is the main culprit.

All commodities, not just oil, take a major hit when sustained oil deflation sets in. A sharp and sustained decline in oil is generally associated with declining sales and prices of other commodities. The entire global commodities sector may be impacted negatively. That has already begun to happen with commodities like copper, gold and other industrial metals, which have begun to fall as well in the wake of the current oil price decline. The Bloomberg index of 22 basic commodities, for example, has recently fallen to its lowest level since 2009.

Even non-oil but commodity-heavy exporting EMEs have experienced significant currency declines relative to the US dollar since global oil prices began to fall more rapidly last June. In recent months Brazil's real has fallen 15.5% and Australia's dollar by 12% - and in both cases despite their central banks' interventions in currency markets to prevent even further currency declines.

Declining currency values set in motion a number of critical economic developments that cause EME economic growth to slow sharply, and even precipitate recessions. For example, sharp declines in currency values lead to capital flight from the EME. Both domestic and foreign investors dump those currencies, buy dollars and send capital out of the country to buy US assets, typically US bonds and stocks and other assets that may be attractive as well, like real estate. The EME capital flight is then reflected in EME stock market declines and a rise in EME government bond interest rates. Flows of foreign direct investment into the EME also slow. Money capital in general dries up. Credit becomes scarce. Falling currency values also lead to higher costs of imported goods for consumers and a consequent decline in consumer real incomes and spending. Business exports also decline. All the above translate into slowing real economic growth in the EME, and even recession. And all because of a rising dollar - the global trading and reserve currency - and the decline in the EME's currency exchange rate that sets the process in motion.

This very process has already been going on, in a muted form, for the past year for EMEs. Talk by the US central bank, the Federal Reserve, of its plans to raise interest rates in 2015 has provoked a number of the trends above already. Note that just the talk of rising rates has resulted in an 'on again/off again' destabilisation of a number of EMEs during the past year. Some EMEs have been able to partially and temporarily offset the effects of a possible rising US dollar - that is, for now. However, should the US Federal Reserve actually raise rates, the effects on EME currency depreciation, capital flight and so on will certainly grow worse.

But even before that 'worse' may occur, the rapid drop of oil prices since last June is having the very same effect right now, in the present, that the US Federal Reserve's policy shift may also have in the near future: that is, it is causing the US dollar to rise and EME currencies to fall, thus setting in motion the aforementioned destabilising effects on the latter's economies. It is just that the oil deflation-rising US dollar effect is impacting the oil and commodity export-dependent EMEs first and most severely at the moment. A more general negative impact may soon follow, and most certainly will sometime in 2015.

Oil deflation's potential impact on the eurozone and Japan

In the cases of the eurozone and Japan, the main risk from global oil price deflation is that falling oil prices will further push already near-zero general inflation rates into deflationary levels. Already the eurozone's general inflation is a mere 0.2% and Japan's less than 0.8%. The central banks of both have a public inflation target of at least 2%, but prices are moving in the opposite direction from that goal, despite trillions of dollar equivalents of euros and yen injected into their economies by the central banks in recent years. Their general price levels have continued to fall.

Should oil deflation push their economies over the cliff into general deflation, it will no doubt be an excuse to inject even more trillions of dollars into their economies, in the false ideological notion that, in today's economy, more money raises the general price level. History has shown this view to be nonsense, of course. Massive central bank liquidity injections result in financial asset inflation, but not in general inflation for goods and services in the real economy. In fact, liquidity injections lead to financial asset bubbles. But oil price deflation will be the excuse, nonetheless, for still more QE money injections in both Japan and the eurozone in 2015. Should further liquidity injections occur, that will contribute even more to financial asset bubbles and instability.

The argument by European policy makers - as by their US cousins - is that lower oil costs will free up income for households to spend on other consumption, as well as add income to businesses which they will subsequently invest. But both premises may prove incorrect. Deflation produces a negative consumer and business psychological effect, a 'deflationary expectations' psychology. Falling prices, i.e., general price deflation, may lead consumers to expect prices to fall still further, and thus cause them to freeze up immediate spending. The same goes for business investment activity. Uncertainty about how far prices for their products may fall by the time they bring them to market at some future date may lead businesses to forgo additional investment even though they have additional income with which to invest as a result of oil cost declines. In other words, deflation is perverse. Deflation in general prices, made possible by oil deflation, may actually result in less consumer spending and less business investment - not serve as a stimulus to both.

Oil deflation and global financial instability

Oil is not only a physical commodity bought, sold and traded on global markets; it has also become an important financial asset since the US and the world began liberalised trading of oil commodity futures (i.e., a financial security) in the late 1990s on a global scale.

Just as declines in oil spill over to declines of other physical commodities (e.g., copper, iron ore, gold, etc.), price deflation in oil financial securities (i.e., oil commodity futures) can also 'spill over' to other financial assets, causing their decline as well, in a chain-like effect.

That chain-like effect is not dissimilar to what happened with the housing crash in 2006-08. At that time the deep contraction in the global housing sector ( a physical asset) not only 'spilled over' to other sectors of the real economy, but to mortgage bonds (i.e., financial assets representing housing and commercial construction), and derivatives based upon those bonds also crashed. The effect was to 'spill over' to other forms of financial assets, which set off a chain reaction of financial asset deflation.

The same 'financial asset chain effect' could arise if oil prices continued to decline to below $60 a barrel. That would represent a nearly 50% deflation in oil prices that could potentially set in motion a more generalised global financial instability event, possibly associated with a collapse of the corporate junk bond market in the US that has fuelled much of US shale production.

Is the US economy an exception?

As in Europe and Japan, the 'talking point' in the US is that global oil deflation will lower consumer and business costs, which will result in more consumption, investment and growth. The counterargument relevant to Europe and Japan, that it could cause 'deflationary expectations' to set in, leading to the opposite impact on consumption and investment, is not as relevant to the US. US general price levels are declining, but much more slowly and from a much higher level around 2%.

The problem with the 'positive growth' argument in the case of the US is that it may not apply due to other, US-specific reasons. The savings to consumers from lower oil and gasoline prices will likely be absorbed by the rise in costs for healthcare, education, rents and other necessities that is now occurring in the US. Another problem is that the rising value of the US dollar, associated with global oil deflation and rising US interest rates, will almost certainly slow US exports and therefore US economic growth.

US growth will also be negatively impacted by falling oil prices because that deflation will bring to a halt the strong investment and expansion of production of shale drilling for gas and oil. At $60 a barrel for oil, shale gas and oil production is not competitive with traditional oil production. Shale production therefore will be significantly reduced, in turn reducing the contribution of industrial production, of which it is a major part, to US economic growth. The shakeout in shale that is coming will not occur smoothly. It will mean widespread business defaults in the sector. And since much of the drilling has been financed with risky high-yield corporate junk bonds, the shale shakeout could translate into a financial crash of the US corporate junk bond market, which is now very over-extended, leading to regional bank busts in turn. In other words, another financial instability event eventually traceable ultimately to global oil deflation.

A final comment

Global oil deflation crossed a threshold of sorts with the 28 November OPEC meeting in Vienna, Austria, at which Saudi Arabia drove a decision by OPEC not to reduce production of crude oil and thus to let the price of oil continue to drop.

The question immediately arises: why this decision by OPEC and the Saudis? Purely business logic would argue OPEC should have voted to cut oil production to support the global price of oil. They didn't. So what's behind the decision? It is likely a combination of several factors.

First, OPEC and the Saudis know that global shale production of oil and gas poses a relatively near-term existential threat to their profits. The Saudis have decided to drive the smaller and more debt-ridden shale drillers and producers out of business. And behind the Saudis on this, no doubt, are the big US oil companies which would like to see the same.

But there could be even more to the story. Saudi Arabia and its neocon friends in the US are targeting both Iran and Russia with their new policy of driving down the price of oil. The impact of oil deflation is already severely affecting the Russian and Iranian economies. In other words, this policy of promoting global oil price deflation finds favour with significant political interests in the US which want to generate a deeper disruption of the Russian and Iranian economies to serve their global political objectives. It will not be the first time that oil is used as a global political weapon, nor the last.                   

Dr Jack Rasmus is the author of the forthcoming book Transitions to Global Depression (Clarity Press, 2015); and Epic Recession: Prelude to Global Depression and Obama's Economy (both by Pluto Press, 2010 and 2012). His blog is jackrasmus.com and website www.kyklosproductions.com, from which this article is reproduced.

*Third World Resurgence No. 293/294, January/February 2015, pp 30-32