My uncle, a noted macroeconomist, recently asked me if I could suggest a fiscal policy rule for oil exporters to help them plan government spending in the face of volatile oil prices.
Of course I could. Here it is.
The model is based on global spending on crude oil as a per cent of world GDP. Oil is the lifeblood of the global economy, and therefore GDP and oil prices tend to be related. If oil prices are too low, supply will falter, the global economy will sooner or later become starved of oil and prices will rise. On the other hand, if prices are too high, then the consumer economies will stagnate, new production will come on line and oil prices will decline.
On the high side, oil spending equalling 5 per cent of GDP implies stagflation, secular stagnation or outright recession in the advanced oil-importing countries. Oil prices are not sustainable at that level without ascribing to some variation of peak oil. Today, 5 per cent of GDP equals about US$110 per barrel. That’s a very high price historically, and not suitable for fiscal planning purposes given current realities.
On the other hand, oil spending is rarely less than 1.5 per cent of global GDP, which would seem to constitute a planning floor. This leaves us with a rather unwieldy range of 1.5 to 5 per cent of GDP for fiscal planning purposes.
But we can narrow this range. Importantly, oil spending rarely falls into the range of 2.5 to 4 per cent. It was in this range for only three years out of the past 35.
We would argue that oil is either supply-constrained or demand-constrained. If it is supply-constrained, then oil will become a shortage commodity, as was the case from 1979 to 1986 and from 2004 to last year, and spending will range from 4 to 5 per cent of global GDP. On the other hand, if the oil supply can respond flexibly to demand, then oil prices will be demand-constrained, implying spending of 1.5 to 2.5 per cent of GDP, with an average of about 2 per cent of GDP.
There is no middle ground, historically. Either oil is a shortage commodity or it is not.
Much depends on one’s view of the future oil supply. If you believe that oil will remain plentiful, then fiscal policy should assume an oil price equal to 2 per cent of global GDP in the long run and perhaps a bit higher in the medium term.
I would add that our expectations depend heavily on the experience after 1986, when oil prices last collapsed in such great magnitude. At the time, a period of extended low prices was readily foreseeable. High oil prices had been maintained by progressive Opec production cuts, which in turn created global spare capacity equalling 13 millionbarrels per day, or 25 per cent of global consumption. This enormous surplus required almost 20 years to clear – two decades known as The Great Moderation. However, there is no such surplus today. Surplus capacity is probably not more than 1 to 2 per cent (1 million to 2 million bpd) of oil consumption, a level that would ordinarily be considered critically low.
On the other hand, the world has roughly 300 million barrels of excess oil and product inventories. Even if drawn at the pace of 1 million bpd, they would last almost a year. Also, shale oil appears to be a scalable resource that can be brought back on line quickly if necessary. If this is true, then a buffer exists – by far not as great as in 1986, but one that might last anywhere from a year through to the rest of the decade.
If one allows the 1986 precedent, then fiscal policy should be set assuming oil prices will equate to 2.3 per cent of GDP, as they did from 1986 to 1990. In dollar terms, that would imply a spot Brent oil price of $50 per barrel today, rising to $60 per barrel in 2020. As Brent hovers near $48 per barrel, the sustainable price would appear to be above the current price.
On the supply side, maintaining such low prices looks like quite a challenge. At current prices, many shale operators are facing bankruptcy, the oil majors are liquidating themselves and Opec governments are suffering for a lack of revenue. The situation looks untenable for producers.
To maintain low prices, China would have to suffer a big setback – one that gets GDP growth down to 2 per cent or less – pushing its neighbours into outright recession. The script would follow the Asian financial crisis of 1998. At the time, oil spending fell to 1.1 per cent of global GDP, equal to $25 per barrel into today’s terms.
Of course, assessing China’s outlook is a complicated matter. For now, let it suffice to say that maintaining current oil prices depends intrinsically on weakness in China, not on the ability of oil producers to flood the market at $50 per barrel Brent.
Those oil exporters who believe that oil is not a shortage commodity should plan for sustainable prices over the next five years at 2.3 per cent of GDP, approximately $50 to 60 per barrel on a Brent basis. For those who believe that China still has a future, and that oil is still hard to find, the analysis will be more complicated.
Steven Kopits is the managing director of Princeton Energy Advisors in New Jersey