$US40 oil is a game-changer

ALAN KOHLER
21 AUG,2015
Spectator
INDUSTRIES RESOURCES AND ENERGY ECONOMY COMMODITIES MARKETS
The drop in the oil price back to just above $US40 a barrel is an unambiguously good thing for the global economy, although you wouldn’t know it by looking at the sharemarket.
The cries of pain from producers drown out the celebrations from consumers because it takes a while for the effect to hit the bowsers, and always does, especially since Australia has so much invested in the fossil fuels.
It was also a factor in the big selloff on Wall Street on Thursday and the global sharemarket correction generally, adding to anxiety about a flight from bonds as the (diminishing) prospect on a US rate looms.
But whatever happens to markets, this country is going to have to get used to the idea that energy stored in ancient, fossilised photosynthesis, of which we have plenty, is now in global oversupply.
This was never supposed to happen. The world was supposed to be running out of oil, but it now turns out that neither of the two pillars of Australia’s resource economy — the other being iron ore — are as valuable as they were, and may never be as valuable again.
In fact much of the world’s known reserves of oil, gas and coal may be in the process of becoming stranded assets.
This is not an argument about climate change, although the transition to solar and wind is probably partly responsible for the collapse in the oil price, but rather an observation that fossilised carbon energy is now being priced according to supply rather than demand.
A collapse in demand caused the oil price to fall in the second half of 2008 to a low of $US32.40 on December 19 that year.
The return to $US100 in 2011 and then a three-year trading range between $US80 and $US110 was also a function of demand, this time rising demand, mainly from China.
But while the price collapse since July last year is partly a result of the slowing Chinese economy, it’s mostly a result of the huge increase in supply within the US as a result of new extraction technology, known as fracking and horizontal drilling.
As a result, the oil price can no longer be taken as a leading indicator of global or Chinese GDP growth, but rather a function of extraction and production costs and the amount of available reserves.
This is a structural, rather than cyclical, change. The new sources of supply that have been unlocked by new extraction technology cannot be locked again.
Meanwhile, the rapidly falling costs of solar and wind power, added to by the development of electric vehicles and large-scale battery storage for solar energy, are, in effect, further increasing the supply of energy.
A glut of oil from better extraction methods, causing energy prices to fall to the same level as during the second deepest demand recession in a century in 2008, is one thing. We could even persuade ourselves, as many in Government are, that coal and LNG will remain fundamental to the Australian economy for a long time to come.
But the shift to using direct sunlight, instead of sunlight that’s been stored in carbon compounds for a few million years, is another matter entirely.
Future historians, surrounded by solar panels and batteries, will no doubt regard the Government’s efforts to promote the Carmichael coalmine in Queensland as the last gasp of another legacy producer trying to fend off the impact of a disruptive new technology.
But the structural decline in the oil price is an unambiguous positive for consumer spending and GDP growth and a negative for inflation, which means it will probably force the Federal Reserve to put off raising interest rates next month.
The Fed has been mumbling about ‘lift-off’ (from a zero Fed funds rate) in September but the minutes released on Wednesday from the July meeting made it clear that this requires inflation to be heading back towards the 2 per cent target that the US central bank has decided is consistent with its mandate.
In fact, the July CPI, also released on Wednesday showed that the CPI rose only 0.2 per cent on a year ago (not a month ago, a year ago), which is well below what the market, and the Fed, has expected.
And that was before the oil price fell from $US60 to $US40.
The latest fall in the oil price is profoundly significant: it both undermines financial markets and supports economic growth.
That makes it the best thing to have happened since China started exporting disinflation in the early 2000s.