Low oil price bad for the economy?

For all of us who fill in our vehicles at the petrol pumps, the recent drop in oil prices is a welcome relief. However, looking at the macro picture, the recent drop in global oil prices (from the highs of around $150 per barrel last year to the current price of $40) may turn out to be a bad thing. Lets see how...

The soaring price of oil in the initial part of 2008, had lead to a spike in the cost of petrol, diesel, etc. It also led to an increase in the cost of virtually everything (all goods have to be transported, and an increase in oil price increases this cost). This obviously hurts the consumers, and since consumers are also voters, governments all over the world started thinking about tackling the oil crisis.

The focus was largely on two things:
Alternatives : Governments seriously started thinking about ways to reduce dependence on oil. This led to an increase in investment into alternatives like wind energy, solar energy, etc. The cost of alternatives was historically higher than oil, however with oil hitting $150, the alternatives suddenly started looking cheap!
New oil exploration : There are huge unexplored oil reserves in non-traditional places like the oil sands of Canada , oil shale in Western US , and deep water oil . At $150 a barrel, companies started exploring these options, as the price of oil was more than the cost of production from these non-traditional places.

Now at $40 a barrel, experts believe that oil has gone below the marginal cost of production! Governments and companies have suddenly shifted their focus away from alternatives and new oil exploration. On an average the marginal cost of production is around $65. It simply doesn’t make sense to invest millions of dollars at drilling new wells when oil futures are selling for $40 or $50. French oil company Total’s CEO recently warned that at $60 oil, a lot of new projects would be delayed.

China currently uses 8 million barrels of oil per day, as against 3.5 million in 1997. China consumes 2 barrels per person, versus 24 barrels per person in the US. The US has 220 million cars for 305 million people, versus 32 million cars for 1.3 billion people in China. There are a host of other countries where the standard of living is rising. Thus; demand for oil will continue to grow in the future.

Adding new oil supply can take decades due to the nature of oil exploration and extraction business. By taking the focus away from alternatives and new oil exploration governments and companies are taking a decidedly short term view. Once the global economy gets on track and the pent-up demand catches up, people will suddenly realize that there is limited supply. This will lead to an oil-shock that will make $150 seem like a bargain! Till then, lets all hope, governments and companies continue to invest and explore more alternatives.




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This post presents a point of view which differs from conventional wisdom. Apart from being a good read (hopefully), it can be a good starting point to help readers, preparing for CAT (IIM) or other MBA interviews, think differently. Since the data / facts for these posts are derived from a host of sources and websites, readers are advised to cross-check the authenticity before using them anywhere.