On crumbling oil prices, Dutch healing and Canada
Cheaper oil – is it a blessing or a curse? Many clients, even those from Europe, have been asking this question lately. Since Europe doesn’t produce oil, it tells us something about the depressed mood there. Even obviously good news seems to be interpreted as having a potential negative impact.
That said, there isn't a straight answer to the question globally or even within some of the oil-producing countries themselves. There is only the “it depends” that economists like to fall back on when confronted with difficult problems. Obviously, the answer hinges on whether you are a producer or consumer of oil. The former’s pains are the latter’s gains. However, the relation is subtler than that in several ways. One only has to imagine oil prices dropping to zero. While consumers might enjoy free heating and motoring, whole industries and, in some cases, countries would go bankrupt. Would the gains really offset the pains?
Or imagine a resource-less country suddenly discovering oil. At first it would see this new source of wealth as a blessing. But its unit labor costs might soon rise. The new oil industry would compete for workers with old manufacturing industries by paying higher wages, pushing up the price of labor. Over time the value of the country's currency would increase, delivering a double whammy to the non-oil exporting manufacturing sector: first, its production costs would soar and, second, its international competitiveness would erode due to an appreciating currency. Ultimately, the oil industry might crowd out other sectors that would have remained successful and competitive had the oil discovery not occurred.
This phenomenon is more than mere theory. It has been observed repeatedly, including, prominently, in the 1960s, when natural gas was detected in the Northern Sea close to the Netherlands. Hence, it has earned the nickname Dutch disease.
As I traveled on a marketing tour through Canada this week the issue on everyone's mind was how the oil-price decline was affecting the country. Fortunately, before I embarked on the trip, one of my colleagues had run the Oxford Economic Forecast© model to assess the impact of a 35% drop in average oil prices (which is the current forecast for 2015 relative to 2014 and assumes a slight price recovery in the second half of the year) on growth and inflation for different countries. While unambiguously negative for the inflation picture in every country analyzed (just the extent of the injury varied), the price drop did not harm GDP in the same unanimous way. Countries that rely heavily on their oil exports, like Russia and Norway, were greatly affected. Net oil importers like China, the Eurozone and even the US experienced a boost.
For Canada the model predicts an impact that is basically nil. True, the plunge in oil prices will cause the Canadian oil industry to suffer, which is why many clients in Calgary and, to a lesser extent, Vancouver were concerned about it. However, given the benefits reaped by the US, Canada's main trading partner, and the fall of the Canadian dollar against its US counterpart that it triggered, clients in Toronto and Montreal were far more relaxed about the issue.
Some of those clients even advanced an inverse Dutch disease – or should I say Dutch healing? – argument. Low oil prices could boost the Canadian economy in the long run because, while negatively affecting 10% of GDP (the size of the oil industry), it lifts the other export-oriented sectors, especially manufacturing. Indeed, the recent 50% fall in oil prices has been mirrored by a drop of almost 15% of the Canadian against the US dollar.
So once again – as is so often the case in economics – a rather simple question has no simple answer. Ultimately, the impact of the steep drop in oil prices might be non-linear. What at first is positive can turn, as it grows in effect, negative and, in the end, if it keeps prices depressed, reverse direction again and take on a positive flavor.