In Part 1, I set out the basic outline of why the fall in the
oil price is good for the global economy, but terrible for financial
markets. In the days after that post, a number of the points made
were clearly illustrated by events.
Firstly, it was argued, in relation to oil and other primary
products, that “those economies that have remained dependent on
their sale as the main source of national income, will be badly
affected, as that income drops.” A
clear example of that was given in the sharp drop in the value of the
Russian Rouble. Its possible to argue that the previous value of the
Rouble was much too high, as I've set out in Oil and The Rouble being based purely on the petro-dollar earnings of the economy. Such
a situation was seen in the 1970's, with the development of North Sea
Oil, and the surge in global oil prices, with the formation of OPEC,
which provided large amounts of revenue for small economies, so that
the value of their currency was inflated.
This led to the so called “Dutch
Disease”, whereby the high
level of the currency made it difficult to export manufactured
commodities from the economy, and simultaneously facilitated their
import. It undermined the domestic economy, and made it even more
dependent upon the sale of oil. One answer to this problem, is to
use these petro-dollars to build up cash reserves, and to reduce the
value of the domestic currency by selling it to buy dollars. The
dollars need to be used, and so are then recirculated to buy US
bonds, and other financial assets. In other words, a surplus on the
country's current account is offset by a deficit on the capital
account. This is one source, of the build up of an excess supply of
loanable money-capital in the period from the 1980's onwards, which
acted to continually push down global interest rates, and also to
push up the prices of US financial assets.
It was not just small northern European economies that enjoyed this
surge of revenue. An even greater fortune was amassed in the Gulf
states, where the production costs of oil were even lower, and where,
therefore, the surplus profits, and differential rent to be obtained,
by the feudal landowners was even greater. With relatively tiny
populations, and economies dependent upon large numbers of migrant
workers, the Gulf states were able to buy off their domestic
populations from these huge revenues, whilst amassing large
quantities of mostly US financial assets. Where oil income was used
for economic development, it was often for the development not of
manufacturing, which would have placed an even greater reliance on
the immigration of foreign workers, but on the development of a
financial services industry within the country.
Secondly, it was argued that,
“Those that have used the higher than average profits only to
build up cash hoards – usually in the shape of sovereign wealth
funds, often invested in the US and Europe – will begin to need to
draw down on those funds to cover the deficits in their domestic
budgets, as their income from trade falls.”
A look at the production costs for a barrel of oil across the various
economies demonstrates this problem. A country like Saudi Arabia may
be able to produce oil profitably at prices as low as $10 a barrel,
whereas North Sea oil production is already making losses, with the
potential for job losses, at prices lower than $60 a barrel. Whilst,
an independent Scotland, would have been placed in a dire economic
situation, as a small economy dependent upon oil revenues for a lot
of its economic activity, and even more so for its government
finance, this is not the case for the UK economy as a whole, given
its more diversified economic base. The fall in oil prices is bad
news for George Osborne, because it means his tax revenue from North
Sea oil production, as well as from VAT on petrol – though not from
Fuel Duty, which is a fixed amount – will fall significantly, but
it would have been disastrous news for the Treasury Secretary of an
independent Scotland, or indeed, for one responsible for an
independently financed Scotland.
Britain, may, therefore, appear to have a bigger problem from lower
oil prices than Saudi Arabia, given the latter's ability to produce
oil profitably at much lower levels, but this is not the case.
Because, Saudi Arabia, is dependent on oil revenues to an even
greater extent than is Scotland, although it can produce oil
profitably at these levels, that does not help the position of its
state finances. Saudi Arabia's state budget requires oil prices of
around $100 a barrel in order to be in surplus. At the current
level, Saudi Arabia, runs a significant budget deficit. An
independent Scotland, currently would need to borrow huge sums on the
global money markets, to cover the gaping hole in its finances that
the drop in oil prices creates. Saudi Arabia, however, can simply
dip into its huge money hoard, built up over the last 30 or so years.
Indeed, Russia, with its $413 billion of foreign currency reserves,
and other reserves held as foreign financial assets, thought to be
around $2-3 trillion, can do the same, rather than needing to
immediately cut its spending.
But, this illustrates another point made in Part 1. Not only
does this mean that the previous flow of petro-dollars into the
global money markets ceases, but also,
“Many will need to draw down their money hoards thereby
increasing demand for loanable money-capital, causing global interest
rates to rise.”
This also illustrates the third point, which is that for all those
economies for which oil represents an input cost to far greater
degree than it represents a revenue, the fall in oil prices
represents good news. George Osborne may lose several billion pounds
in tax from the fall in the oil price, but British capital, which
sees the amount it must advance to cover its energy costs, its
transport costs, or for the important petro-chemical industry, its
raw material costs, fall significantly this represents not just a
significant boost to the rate of profit, but a release of capital
that can be used for further accumulation, and consequent economic
growth. The same applies for all of the consumers, who have revenue
released for spending on a range of other commodities, the demand for
which will thereby rise, especially as the prices of those
commodities falls too, in response to the fall in their own input
costs. What Osborne loses in North Sea and petrol taxes, he more
than makes up for in the increase in VAT on the sale of these other
commodities, as well as in income taxes resulting from the higher
level of economic growth resulting from lower oil prices. In the US,
the fall in the oil price, is estimated to have put an additional $1
trillion into consumers pockets, that can be used for the purchase of
other commodities.
The extent to which the fall in the oil price will have an economic
contractionary effect offsetting this expansionary effect is hard to
tell. It is wrong, for example, to assume that just because some
particular production is unprofitable, it must close down. As I've
set out elsewhere, for primary products, large capitals have to adopt
a long time-scale. They have to build up cash reserves during
periods of high prices, so as to run them down during periods of low
prices. A producer of oil, therefore, may continue to produce even
if the current price per barrel does not cover the total cost of
production per barrel, provided that the current revenue exceeds the
current variable costs, and so makes a contribution to the fixed
costs of production.
For smaller producers, especially where they have used loaned
money-capital, rather than their own, and where, therefore, they must
continue to make interest and capital repayments, the lack of
adequate financial reserves, will mean they go bust. But, even this
does not mean that the production and supply gets taken out. When
the firm goes bust, all of the sunk costs – the costs of
exploration, of sinking wells and so on – get written off. To the
extent that they were financed from loaned money-capital, it is the
bank or other financial institution that loses their money, to the
extent it was financed by bondholders or shareholders, it is they
that lose their loaned money-capital, i.e. the fictitious capital.
But, the real capital still exists, i.e.. the oil wells, mines,
quarries etc. Their value may have been significantly depreciated as
a result of this process, and consequently some new, usually much
larger capital, picks it up for more or less nothing, as it buys the
company lock, stock and barrel. As Marx sets out, it is not the
physical destruction of capital that facilitates a recovery of the
rate of profit, and economic growth – that would be ridiculous
because a capital that is physically destroyed can produce nothing,
including profit! - but only the destruction of its value.
“A large part of the nominal capital of the society, i.e., of the exchange-value of the existing capital, is once for all destroyed, although this very destruction, since it does not affect the use-value, may very much expedite the new reproduction.”
(Theories of Surplus Value, Part 2, p 496)
So long, therefore, that this new capital can sell a barrel of oil at a price that covers its current production cost, it is enabled to make profits, and because the value of the fixed capital has been massively reduced, its rate of profit, is thereby significantly increased.
As Marx puts it,
“This is one of the reasons why large enterprises frequently do not flourish until they pass into other hands, i. e., after their first proprietors have been bankrupted, and their successors, who buy them cheaply, therefore begin from the outset with a smaller outlay of capital.”
(Capital III, Chapter 6, p 114)
This may well be the case with North Sea and other deep water oil production, therefore. However, it is not necessarily the case for oil produced by fracking. Often the fixed costs of such production may not be so great, because a lot of this production can take place without the need for exploration. Existing oil deposits, that were previously thought to have been economically exhausted, are simply subjected to these new technologies so as to extract remaining oil. However, it is then the current costs, which tend to be much higher than for conventional drilling. In order to fracture the rock and extract the oil, not only is more expensive, more sophisticated equipment required, but there is a considerable cost in respect of auxiliary materials, in the shape of the chemicals that must be pumped into the rock to cause the fracturing. Its not clear, therefore, that even where the fixed costs of production are written off, that many such facilities would be profitable at prices below $60 per barrel.
Given the extent to which these capitals have been established on the basis of loaned capital raised in the junk bond markets, it is no wonder that these bonds have been selling off rapidly. I will look at this in more detail in the next posts.
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