In reflecting on the first half of 2016, we see some positive signs amidst the turmoil. Over the long-term, the economy appears to becoming less responsive to volatile commodity prices such as oil. This is a great thing for global innovation as it reduces global uncertainty, permitting the longer term planning required to innovate in some of the most challenging sectors. This is one of the benefits from the Clean Energy revolution that few consider.
2016 had a Tumultuous First Half
So far, 2016 has been a tumultuous year for the global economy. Industries, markets, and governments are currently evaluating their exposure to Britain’s pending departure from the EU. The Brexit vote is the latest of many shocks the global economy has experienced throughout the year. At the beginning of 2016, private tech companies took a beating as the disconnect between public and private valuations caught up with Silicon Valley. Deal activity has since rebounded, although companies have been hesitant to move towards initial public offering (IPO) in this environment. However, the recent IPO of Twilio on June 23rd looks to be highly successful and may restore some confidence in tech IPOs.
Oil prices took a beating at the same time as private tech equity. In January, West Texas Intermediate fell below $30USD/bbl, its lowest price in 14 years. This had some pundits discussing the possibility of oil becoming worthless; calling it “$0 a barrel oil”. Oil has since recovered to around $50USD/bbl, a less catastrophic price for the oil industry, but still considered very low.
Amidst all this turmoil and uncertainty, economic growth has been slow but steady. The data is not pointing to any big news in the near term. Something great will happen, but it is unlikely to happen tomorrow. This does not mean it is all doom and gloom though. While some industries will see tremendous growth, most will simply putter along.
The U.S. central bank lowered its economic growth forecast for 2016 to 2.0 per cent growth, from 2.2 per cent, and its outlook for 2017 was also set to 2.0 per cent from 2.1 per cent. This basically means the economy is expected to stay the course for the next few years. This is not a bad thing, but it does mean that there is no good news for the masses of unemployed across the U.S.
The Markets are Challenging Core Economic Assumptions Regarding Oil and Growth
Considering the lack of forecasted growth, where is the good news? Perhaps it is in what we are learning about the global economy and its resiliency. In particular, long-held assumptions about relationships between oil prices and growth have being challenged. Growth drivers seem to have shifted to clean energy and other innovations, especially in countries with mature economies.
“The economic impact of the oversupply is another enigma. Cheaper fuel should stimulate global economic growth. Industries that use oil as an input are more profitable. The benefits to consuming nations typically outweigh the costs to producing ones. But so far in 2016 a 28% lurch downwards in oil prices has coincided with turmoil in global stock markets. It is as if the markets are challenging long-held assumptions about the economic benefits of low energy prices, or asserting that global economic growth is so anaemic that an oil glut will do little to help.” The Economist, Jan. 2016
The Economist further points out that “Iran is the most immediate cause of the bearishness.” We strongly disagree with this assessment. Rather, the inability of low oil prices to assist economic growth is a reflection of a more fundamental shift in the economy. The Economist is correct; we need to challenge our long-held assumptions. We are dealing with systemic changes that span across all areas of the economy. Oil is no longer the leading indicator it was, and it probably never will be again.
The Link Between Oil and Energy Prices is Weakening
To understand the shift, it is useful to return to the idea of “$0 a barrel oil”. The inspiration for this discussion was an analysis by the Federal Reserve Bank of St. Louis. They came to the following conclusion:
“According to our calculations, oil prices would need to fall to $0 per barrel by mid-2019 in order to validate current inflation expectations. After that, there is no oil price that would allow our model to predict a consumer price index (CPI) path consistent with December 2015 breakeven inflation expectations. This implied path of oil prices is very different from the path of oil prices implied by futures contracts, which rises to more than $50 per barrel by mid-2019.”
The model that was used by the St. Louis Fed is well supported by 20 years of data, but since releasing their analysis in February, WTI Crude Oil futures prices have turned out to be fairly accurate (oil is not going to $0 a barrel anytime soon). Inflation expectations haven’t changed much either. It appears the assumptions underlying a model that has worked for 20 years are in question. Oil price may no longer be the core driver of global energy price (and through it, inflation).
There are some plausible explanations for this:
- Global energy consumption is rising faster than oil consumption, which means oil’s share of global energy production is decreasing.
- An increasing number of regions are putting a price on GHG emissions, which means a large portion of the variable cost of turning a barrel of oil into energy is now in the emission credits or carbon tax. At a price of $15 per metric ton CO2, it costs around $6 in carbon emissions per barrel to produce energy.
- Oil is facing dramatically increased threat from substitutes. The cost of producing renewable energy through solar, wind, and biomass is becoming much more competitive. While renewables (excluding hydro and nuclear) still only supply 6.7% of world energy supply, that share is increasing by around 0.5 percentage points per year. That growth rate is expected to continue and possibly accelerate as Asia, Africa, and the Middle East ramp up their investments in renewables.
- Innovation in CleanTech and IT are increasing competitiveness, putting downward price pressure on both renewables and oil. For example, smart grids and other demand-side controls increase the bargaining power of end energy users.
Source: BP Statistical Review of World Energy, 2015
An Economy Where Oil Price Does Not Matter
The overall economy becoming less responsive to volatile commodity prices (such as oil) is potentially a great thing for global innovation. It reduces global uncertainty which permits the longer term planning required to innovate in some of the most challenging sectors. This is one of the benefits from the Clean Energy revolution that few consider. There are many other factors that are shortening planning horizons, such as the pace of disruptive technology development. Anything that can counterbalance this is a welcome addition.