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ECONOMY: Towards Lower Oil Prices

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By Peter G. Hall, Vice-President and Chief Economist EDC *

Few economic indicators grab the attention like oil prices. Large swings in recent years have led to statements in the popular media that in retrospect are comical. The upward run of prices between January and April led some to label this the greatest threat to continued world growth. They might have been right, but the recent plunge should quell those fears. Instead, other worries predominate. Should they, or are lower oil prices a hidden elixir for the world's woes?

Crude oil's recent wild ride in the past year is easy to forget. World weakness weakened WTI crude to the mid-US $80 per barrel range last summer. Accelerated growth moved prices up to the US $100 per barrel level in the fall, gaining an additional 5 per cent earlier this year. Since early May, prices have sunk back close to US $80 per barrel. The same goes for Brent crude - it has shed US $25 per barrel over the same period.

Gasoline prices have responded, most notably in the US. Just in time for the critical driving season, pump prices are down a substantial 24 per cent to US $2.50 per gallon. Declines are less dramatic in most other markets, where prices are either more heavily managed or blurred by significant taxation. Even so, the stimulative effect on the global macroeconomy cannot be denied.

How significant is it? The US Energy Information Administration estimates that a $20 drop in oil prices adds roughly 0.4 per cent, or $60 billion, to US GDP. Other rules-of-thumb suggest that a 50-cent drop per gallon in gasoline prices adds $70 billion to the economy, making the recent price drop a $100 billion windfall, almost 0.7 per cent of GDP. Given recent strength in US consumer spending, it's not hard to imagine the early-summer bonus having an impact at the till in the coming weeks.

So far, there's not much sign of enthusiasm. To date, US retail sales haven't reacted, and confidence has been battered on both sides of the pond by concerns about Europe. Those concerns may initially lead consumers to save a greater share of the oil-price windfall, but even the muted boost is likely to prompt greater use of the spare cash as the year wears on.

OECD nations should generally show positive spending impacts in the second half of this year. But the effects aren't limited to the largest economies - fuel costs are significant in emerging markets, although translation to consumers is dampened by subsidies that in many cases are a substantial share of the total cost. But on the flipside, lower prices will ease the burden on public finances, creating room for other avenues of government spending.

Oil producing nations aren't as happy. Russia in particular has an expensive set of stimulus measures that will take $120 oil to pay for - but it's likely an exception. Most oil plays make good money at prices well below current world rates. As far as we can tell, most if not all Canadian producers are still making money at current prices, although profits will take a big hit.

The bottom line? Bad news sells, and it's currently carrying the day. Ironically, the effect of this on crude prices could be a key factor that perpetuates the world-leading momentum in the US economy. Lower oil prices could be the biggest upside surprise to hit the world in the second half of 2012.

The views expressed here are those of the author, and not necessarily of Export Development Canada. ©EDC

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