Undercover Economist

The consequences of cheap oil

‘When oil prices are high, people may get out of their cars and walk, cycle or get public transport’

After years in which $100 oil was the norm, the price of Brent crude is now around a third of that. Assume for a moment that Russia and Saudi Arabia fail in their efforts to get the price back up. Will $30 oil change the world? The answer is yes, of course. Everything is connected to everything else in economics, and that is particularly true when it comes to oil. For all the talk of the weightless economy, we’re not quite so post-industrial as to be able to ignore the cost of energy. Because oil is versatile and easy to transport, it remains the lubricant for the world’s energy system.

The rule of thumb has always been that while low oil prices are bad for the planet, they’re good for the economy. Last year a report from PwC estimated that a permanent fall in the price of oil by $50 would boost the size of the UK economy by about 1 per cent over five years, since the benefits — to most sectors but particularly to heavy industry, agriculture and air travel — would outweigh the costs to the oil production industry itself.

That represents the conventional wisdom, as well as historical experience. Oil was cheap throughout America’s halcyon years of the 1950s and 1960s; the oil shocks of the 1970s came alongside serious economic pain. The boom of the 1990s was usually credited to the world wide web but oil prices were very low and they soared to record levels in the run-up to the great recession. We can debate how important the oil price fluctuations were but the link between good times and cheap oil is not a coincidence.

Here’s a piece of back-of-the-envelope economics. The world consumes nearly 100 million barrels a day of oil, which is $10bn a day — or $3.5tn a year — at the $100 price to which we’ve become accustomed. A sustained collapse in the oil price would slice more than $2tn off that bill — set against a world economic output of around $80tn, that’s far from trivial. It is a huge transfer from the wallets of oil producers to those of oil consumers.

Such large swings in purchasing power always used to boost economic growth, because while producers were saving the profits from high prices, consumers tended to spend the windfall from low ones. One of the concerns about today’s low prices is that the positions may be reversing: the big winners, American consumers, are using the spare cash to pay off debts; meanwhile, losers such as Russia and Saudi Arabia are cutting back sharply on investment and public spending. If carried to extremes, that would mean a good old-fashioned Keynesian slowdown in a world economy trying to spend less and save more; the more likely result of which is that lower oil prices fail to give us the boost we hope for.

It is intriguing to contemplate some of the less obvious effects. Charles Courtemanche, a health economist at Georgia State University, has found a correlation between low gasoline prices and high obesity rates in the United States. That is partly because, when oil prices are high, people may get out of their cars and walk, cycle or get public transport. Cheap gasoline, on the other hand, puts disposable income into the pockets of families who are likely to spend it on eating out. Low oil prices may make us fat.

Another depressing possibility is that low oil prices will slow down the rate of innovation in the clean energy sector. The cheaper the oil, the less incentive there is to invent ways of saving it. There is clear evidence for this over the very long run. As recently as the late 1700s, British potters were using wasteful Bronze Age technology for their kilns. The reason? Energy was cheap. Wages, in contrast, were expensive — which is why the industrial revolution was all about saving labour, not saving energy.

More recently, David Popp, an economist at Syracuse University, looked at the impact of the oil price shocks of the 1970s. He found that inventors emerged from the woodwork to file oil-saving patents in fields from heat pumps to solar panels.

It is always possible that the oil price collapse will do little to affect some of the big technological shifts in the energy market. The scale of oil production from hydraulic fracturing (fracking) in the US may be curtailed but a huge technological leap has already happened. As the chief economist of BP, Spencer Dale, recently commented, fracking is starting to look less like the huge, long-term oil-drilling projects of the past, and more like manufacturing: cheap, lean, replicable and scalable. Low oil prices cannot undo that and the efficiencies may well continue. We can hope for ever-cheaper solar power too: photovoltaic cells do not compete closely with oil, and we may continue to see more and more installations and lower and lower prices.

That said, when fossil fuels are cheap, people will find ways to burn them, and that’s gloomy news for our prospects of curtailing climate change. We can’t rely on high oil and coal prices to discourage consumption: the world needs — as it has needed for decades — a credible, internationally co-ordinated tax on carbon.

Written for and first published at ft.com.

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