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Oil's fall: an opportunity for manufacturers

Analysis

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South Australian economist Michael O’Neil analyses the impact of falling oil prices – and finds that Australian manufacturers and entrepreneurs face a one in a lifetime opportunity.

Beginning approximately in December 2008, the US Federal Reserve responded to the impact of the Global Financial Crisis by progressively reducing interest rates and embarking upon a program of asset purchases or ‘bond-buying’ (i.e. expansionary monetary policy) which became known as ‘quantitative easing’.

Up to October 2014 when the program of quantitative easing came to a halt it is estimated that the US Federal Reserve injected some $US 4.8 trillion into the domestic economy.

It has taken some five to six years to turn around the US economy but there are positive and recent signs of greater strength in the domestic economy that growth has returned, that employment is expanding and unemployment falling, company balance sheets are primed for capital equipment investment and the $US dollar has strengthened. This last point is important simply because oil prices are denominated in US dollars.

In mid-November 2014 world crude oil prices commenced their freefall seemingly in response to subdued worldwide demand, an increase in supply from shale oil extraction and maintenance of existing levels of output by the major world oil producers.

In short, supply is greater than demand so the price must fall. These two factors combined – the strengthening of the $US dollar and the level of production – are behind the dramatic decline in the price of crude oil and the local price at the petrol pump.

There are international ramifications in all this. Those countries that are highly dependent on oil revenues will experience a significant decline in export revenue. Russia as an oil-exporting country will experience a further “western induced monetary sanction” for the penalty of invading Crimea and Ukraine; emerging economies will benefit from lower oil prices and a reduction in domestic inflationary pressures; lower oil prices should underpin a forecast increase in the rate of GDP growth especially in China and the USA and contribute to a more positive outlook in Europe.

What impacts might we see for the consumer, for investment and exports for Australia?

For the individual consumer, well you just got a “tax cut”. To the extent oil and LNG are substitutes, then there may be some incentives for switching, but in the international export market most country-to-country contracts are long-term and not subject to change with fluctuations in the price level of either commodity . The return on investment given the world price for a barrel of oil (sub $US50 and falling) may see a contraction in shale oil exploration and development. A contraction in traditional oil and gas exploration might also follow and already industry analysts point to a reduction in operating rigs worldwide.

Oil is a significant input into production, so production input costs are forecast to fall along with an easing of emerging upward pressures on consumer price inflation. The Reserve Bank is likely to sit tight and watch worldwide events so there is not likely to be any further cuts to the official cash rate and hence your mortgage interest payment obligations.

Australian manufacturers and entrepreneurs face a once in a life time opportunity offered by a falling $A potentially below US80 cents, the recent free trade agreement with China and a similar agreement in prospect with India, lower input costs, slow wages growth and stable inflation below the RBA target zone.

Now is the time for government to review and make the necessary regulatory changes (sector by sector) that result in overall lower input costs and transport costs (‘goods to markets’ costs) for our exporters, to support the conditions for business expansion and capital investment that offer the greatest scope for employment growth and soaking-up underutilised labour in our labour market.

For South Australia, the sectors that should be first cab of the rank are those in the broader agricultural sector, our existing aquaculture exporters, transport services and reforms (i.e. introducing greater competition) to utilities.

Associate Professor Michael O’Neil is Executive Director of the South Australian Centre for Economic Studies.

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