Oil Price. Good For The Economy, Terrible For Financial Markets - Part 2

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.

Back To Part 1

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