It is common wisdom that the oil price "shocks" of the 1970s were disastrous for the world economy. After each of the two main price increases--in 1974 and 1979--inflation climbed, the world sank into recession and international financiers and officials worried about strains in the world's banking and trade system.
Now, with the breakdown of last weekend's meeting of the Organization of Petroleum Exporting Countries, there is a chance that oil prices will drop sharply. Why isn't everyone cheering?
For one thing, an assessment of any price change depends on your point of view. For oil producing and exporting countries, a price decline is obviously a bad thing, at least at first, as they lose money from oil sales. High-cost producers in particular, such as many of those in the United States and in the North Sea, would see profits deteriorate swiftly if prices fell. Bankers and businessmen with a lot of money at stake in energy production also get hurt if oil prices drop, as this means a drop in the value of their investments.
But for all these losers there are also big potential winners. Oil importing countries--from the United States, to Brazil, to many of the poorest nations in Africa--will be able to get the same amount of oil for less money. Companies hurt by rising fuel prices, such as the airlines, will benefit significantly if fuel costs fall instead. Consumers will have more money to spend on other things if they pay less for gasoline, for example, or for home heating oil.
Deciding whether an oil price decline is a good or bad thing does not, however, depend simply on comparing winners with losers. Many analysts believe that lower oil prices will lead to cumulative gains for the world as a whole, just as the price hikes in the past decade hurt the world economy.
An oil price decline is "a positive-sum game," Robert Solomon of Brookings Institution said. The world as a whole will be better off if oil prices decline, he said, because this will boost spending and output in the oil-importing nations and help to ease inflation worldwide.
Solomon and many other economists likened the oil price increases in the 1970s to a sharp increase in an excise tax. Consumers of oil suddenly had to pay more to keep buying the same amount, just as when an excise tax is imposed. Since their incomes did not go up at the same time, the oil price rise meant a squeeze on spending which resulted, in time, in lower output and fewer jobs.
As governments later moved to quash the inflation that rising oil prices produced, the depressing impact on growth and employment intensified.
A drop in oil prices would have the opposite effect, Solomon says. As oil consumers spend less on energy, they will spend more on other things. This extra demand will then feed through to higher production, more jobs and higher incomes across the economy. Nations now spending a lot of their money on imported oil would have more to spend on other imports. World trade in general should thus benefit, according to this analysis.
There is some offset to this boost to the world economy. The excise tax analogy for the world assumed that when oil-producers "levied" higher prices, they did not immediately spend the additional funds. However, over time, oil producers have spent more and more of their incomes. A drop in oil prices would hit such spending directly. Some energy investments would likely be canceled. Oil-rich countries with less money to spend may cancel or reduce their orders from overseas. These negative effects of a price decline would in turn go to offset some of the positive impacts on world spending and output.
But, meanwhile, a price decline would also help oil consumers by transferring real income to them and away from producers. Although there are many U.S. energy producers, the nation remains on balance a net oil importer, last year importing more than $60 billion of oil. Thus, a drop in oil prices will transfer real income and spending power to the United States and provide a net gain in national income, without anyone having to produce any more, or work harder than before.
"People [who use oil] are going to be richer . . . a genuine price movement in your favor really makes you richer," stressed one New York financier last week.
To be sure, the United States will not benefit as much on this count as some other nations that are more dependent on imported energy. West Germany, France and Japan would be major beneficiaries among the industrialized nations from an oil price decline, while Brazil, Korea, Taiwan and India are all major developing-country oil importers.
For the non-oil developing countries overall, oil accounts for about 20 percent of imports, an international expert said last week. There are, moreover, more oil consumers than producers in the Third World. Developing countries, excluding OPEC members such as Venezuela, Nigeria and Indonesia, exported about $28 billion of oil last year. In contrast, this group of poor nations spent $67 billion on importing oil, a New York expert said last week.
Another important plus from a falling oil price is, of course, the gain on inflation. Just as soaring oil prices in the 1970s exacerbated worldwide inflation, so declining prices now would help ease price pressures. A Federal Reserve official commented last week that "the world has to better off" if oil prices decline. "It would enormously increase our chances of keeping inflation down."
Federal Reserve Governor Henry Wallich agrees. He said that while a price drop would create problems for some particular groups, "worldwide it's obviously a blessing."
There are, however, many analysts who worry about the possibility of an OPEC price war, and a plunge in oil prices.
"Just as so much depended on how [oil prices] went up, a lot also depends on just how" they come down, Daniel Yergin, president of the Cambridge Energy Research Associates and a Harvard lecturer, commented. "We have already had a 25 percent decline in the real price of oil since March 1981," he pointed out, adding that it would be "healthy" if this price erosion continues.
However, if prices fall steeply and suddenly, this "could be as destabilizing" as a sharp price increase, he said. "A great deal of lending in the United States and overseas has been predicated on a barrel of oil costing so much . . . if the price plummets so much investment and lending would be undermined that it could lay the foundations for a third oil shock," which would be as damaging to the world as the first two, he said.
He puts the danger area at about $25 to $28 a barrel. At present the OPEC benchmark price is $34, while the average effective price is closer to $32, a Washington oil expert said last week. Most analysts still believe that a swift decline of as much as $10 a barrel is very unlikely or, that if it did happen, it would prove to be unsustainable. However, the United Arab Emirates' decision late last week to raise oil output by a dramatic 45 percent has increased the likelihood of a price collapse, analysts said.
There are two different sorts of problems associated with a such sudden price drop, apart from the direct difficulties it would pose for those producing and selling oil.
The first, and most frequently mentioned, is that an already fragile international banking system would be placed under much greater strain. The pain from an oil price decline would be concentrated, and some of the sufferers include nations which are already causing bankers considerable anxiety.
Chief among them is Mexico, which has $55 billion of bank debt, according to the latest figures from the Bank for International Settlements, and has already been forced to reschedule its debts and go to the International Monetary Fund for help. Mexico would lose about $5 billion a year in oil revenues if the price dropped $10 a barrel, experts say. It would have to borrow still more money from reluctant commercial banks, or governments, if its oil income nose dived.
Within the United States, many high-cost producers in the Southwest would be hurt and perhaps ruined by a deep drop. Other energy producers, such as the coal industry, would also suffer. Weak oil prices have already contributed to one spectacular bank collapse: the Penn Square failure of last summer. When it closed its doors, largely because of bad oil loans, the ripples were felt throughout the financial markets.
A "cascading" decline in the oil price could create "a real problem" for the financial system, a senior Federal Reserve official said. A "10 percent decline, or something like that," would probably not be "too big a deal," he said. But a sharp fall, or a collapse in the price, is "bound to add to the strains in the financial system" which are already a potential barrier to economic recovery.
The oil exporting nations that are most vulnerable to a price decline include Mexico, Venezuela, Nigeria and Indonesia, analysts say. But of these, Nigeria and Indonesia each have less than $5 billion of bank debt. Venezuela has quite large reserves and bank deposits to offset its $22 billion of bank debt.
Some analysts are less worried about the dangers to the world system. If there is a potential banking problem from falling oil prices "it's confined to Mexico and Venezuela," one Federal Reserve official said. This official believes that "even if we have to bail out some banks" it would be worth it in exchange for the growth, and reduction in inflation, that an oil price drop would bring.
Another monetary expert pointed out that despite the well publicized Mexican debt problem, many OPEC countries are still in a relatively favorable financial position compared with the non-oil countries that would benefit from lower oil prices. "The Brazilians would love" a price decline, one analyst said. Several stressed that all debtor nations, oil and non-oil, would benefit hugely from a decline in interest rates and revival in the world economy.
The second potential problem from a sharp oil price decline comes if the decline is not sustainable. In this case, the benefits to growth and inflation must be set against the costs of less energy conservation, a slowdown in the development of new energy sources and the installation of new energy-intensive investment that would become less economic again.
If the oil price falls way below a long-term equilibrium, then the foundations could be laid for another round of dramatic and damaging price increases, an oil expert said. "Your view about the desirability of a decline depends on your view of the likely oil price in three years' time," one senior U.S. official remarked. If the likelihood is that prices will rise again with world recovery then there is not much point in having the "intervening decline," he said.
It is partly for this reason that many predict the United States and other industrialized oil importers would decide to tax imported oil if the price does drop significantly. A tax would reduce the boost to consumption and output from any price decline as consumers would effectively be sharing with the Treasury the benefits of the income transfer from oil exporters. But governments could choose to use the extra revenue to subsidize continued conservation and energy development, or to cut overall taxes so the economy received the same size boost from the price decline, but without the bias in favor of more oil consumption.
A third, but bogus, problem has also been raised about a price decline. If OPEC countries have less cash to lend, the argument has run, then needy countries will not be able to borrow what they need and interest rates might go up. However, for every dollar less in oil exporters' pockets, there is a dollar saved by an oil importer that can either be used instead of a loan or lent to a nation that needs it.
Clearly, an oil price decline could not be hailed as an unqualified boon for the world. But even those most anxious about its potential dangers generally agree with one thing: A price increase would be even worse.