Oil, trade and the world economy... plus Ferraris and Zombie Ships

29 Jan 2016

Tags

  • Mark Thirlwell
  • AIBS 2015
  • International Trade
  • World Economy

As mentioned in one of last week’s posts, one of the developments that has been unnerving financial markets this year has been the sharp drop in commodity prices in general and in the price of oil in particular.

Monthly oil price, US$/barrel, simple average of Brent, WTI and Dubai Fateh 

On the face of it, treating (much) cheaper oil as a major source of market angst might seem a little strange. After all, the conventional view (pdf) has usually been that the impact on the world economy of a fall in oil prices depends on what’s behind the drop. In particular, if the main explanation is an increase in the supply of oil, then the standard story runs as follows: Lower prices will be good news for (net) oil consumers/importers: as long as the price falls are passed on, households will see a fall in the cost of living and an increase in their disposable incomes while businesses will benefit from a fall in input costs. Sure, at the same time, (net) oil producers/exporters will suffer a decline in their incomes, so at the global level overall gains for consumers/importers will be offset by losses for producers/exporters. But, the story goes, the net effect on activity will still be positive, as past experience shows that the induced increased spending by importers/consumers has typically exceed the fall in spending on the part of producers/exporters.

Since the most important explanation for the current fall in prices seems to revolve around an increase in supply – the International Energy Agency warned recently that global oil markets could ‘drown in over-supply’ – the traditional story would see the decline in oil prices as positive for global activity.1 And as the RBA explained last year, the same basic story would be expected to apply both to Australia’s trading partners and to the Australian economy itself.

So why have markets been so spooked by cheaper oil? There are several possibilities: Maybe the fall in oil prices is actually as much about weaker demand as it is about increased supply (an argument closely linked to the ongoing fears about China’s growth profile;2 maybe the assumption is that the scale of the pain inflicted on oil producers will this time outweigh any gains for oil consumers; perhaps the fears are about the potentially destabilising political and geopolitical consequences of lower prices via the impact on some key producing countries and regions; or maybe the concerns relate to shifts in global capital flows as major sovereign wealth funds and other oil-funded investors are forced to keep more of their money at home, or to a financial market shock via the damage to the creditworthiness of vulnerable energy companies? Or some combination of all of the above.

Another possibility, set out in a recent piece by Olivier Blanchard, the former head of economic research at the IMF, suggests that the current bout of market nerves is just that: investor anxiety at a time of unusually high uncertainty about the future direction of the global economy.

At the moment, the jury is still out. Meanwhile, might we see some benefit from cheaper oil via world trade flows? Before the global financial crisis, the world economy experienced a sharp increase in oil prices, from around US$30 per barrel in 2001 to more than US$100 per barrel by 2008. Back then, that rise sparked a series of warnings that high prices would feed through into increased transport costs which would in turn undermine globalisation (pdf, see pp. 4 – 7), with high transport costs having the equivalent impact of a nasty increase in trade tariffs. Recent work by economists Pierre-Louis Vézina and David von Below finds that in years of higher prices, trade does indeed become less global as distance starts to matter more. It therefore follows that the current fall in prices could potentially give a useful boost to international trade via lower trade costs.

With global trade still struggling to gain any momentum, a reduction in trade costs would certainly be welcome. And we know from the results of our survey work that Australian exporters in general find transport costs important: according to AIBS 2015 for example, some 65 per cent of respondents said that the cost of transporting their product from Australia to a target market was an important restriction on their ability to take advantage of new international opportunities.

Restrictions on taking advantage of new international opportunities 

That said, economists disagree over precisely how important the impact of the oil price on overall trade costs might be.3 For example, according to one set of estimates, transport costs only account for perhaps one third of total trade costs, with the balance made up by factors including informational barriers (another result that is emphasised by our survey work), formal trade barriers and red tape, implying that the direct link between oil prices and total trade costs may be limited.

Finally, the falling oil price isn’t the only factor influencing transport costs right now. The combined impact of a decline in demand plus an excess supply of ships has seen the Baltic Dry Index, a measure of the cost of shipping bulk freight such as iron ore, coal and wheat, fall to record lows this month, with the index dropping below 400 for the first time since it started to be published in 1985. According to one estimate, it’s now appreciably cheaper to hire a 1,100-foot merchant vessel for a day than it is to hire a Ferrari for the same amount of time.4

The Baltic Dry Index, index monthly values 

The collapse in freight prices has also produced the phenomenon of co-called ‘zombie ships’ as owners keep loss-making vessels afloat. These zombie vessels help keep downward pressure on freight rates, and by lowering operating costs, the fall in oil prices might keep the zombies above water for a bit longer.

1 Perhaps with an important caveat regarding the negative short-term impact on capital spending in the energy sector, particularly post the shale boom, as the latter seems to have increased the speed at which capital spending responds to swings in the oil price.
2 Although as yet there seems to be little evidence of a direct link between Chinese demand trends and the oil price, with China using the low price to build up its emergency oil reserves.
3 Gosh, economists disagreeing! I suspect you’re (not) surprised.
4 Admittedly, the substitutability between these two kinds of transportation is not immediately obvious...