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ANALYSIS

Sustained price drop... beneficial to large economies

Oil price drop – a developing positive shock

DUBAI, November 11, 2014

While the recent drop in oil prices poses a positive shock to the global economy, sustained cheaper oil could drive global GDP growth by a few tenths of a percentage point (pp), benefiting large developed economies and much of Asia, a report said.

This week’s global activity data painted a mixed – and familiar – picture, explained the recent report from the Bank of America (BofA) Merrill Lynch Global Research titled "BofA Global Economic Weekly – “Oiling the machine”.

The October employment report and business surveys suggest US growth remains solid. Euro area confidence and production data show the economy has been barely moving. Meanwhile in emerging markets (EM), business confidence softened in China and Brazilian industrial production contracted in September.

While better than feared last month, the tone of the latest data is unlikely to assuage growth concerns, according to the BofA Merrill Lynch Global Research report.

However, some tailwinds are blowing. On the policy front, the Bank of Japan has expanded easing targets and this week’s ECB meeting kept the chances of sovereign QE alive. The chances of more forceful easing by the PBoC have also been on the rise. But perhaps the most significant growth support in the short term will come from lower oil prices. (Brent oil prices have dropped by about 25 per cent since June).

The decline partly reflects expectations of weaker demand growth, as well as the strengthening dollar. Yet, commodities team sees rising supply as the main driver behind the move. This positive supply shock is likely to support global growth, but the boon will likely not be felt evenly across countries, according to BofA Merrill Lynch Global Research report.

Is it ok, good or great news?

Any oil shock worthy of the name stands out from the usual price volatility. This is one motivation behind the net oil price increase index (NOPI) suggested by UCSD Professor James Hamilton. The index only records price changes that exceed the highest price seen over the previous three years.

“For illustration purposes, we look at a variation of the NOPI index capturing both price hikes and drops that move past the highest and lowest level registered during the previous three years, respectively,” said the Global Economics team at Bank of America Merrill Lynch.

The latest move seems significant, comparable to most shocks seen over the past decade. It is not clear, however, that price drops have a similar impact to that of price hikes. There are indications that oil price jumps hurt the US economy by more than the boost from comparable price slides. But this is difficult to establish for many EM economies, where the impact of oil shocks is felt primarily on the fiscal side. This adds uncertainty to impact estimates, said the BofA Merrill Lynch Global Research report.

Some welcome reprieve

“To simulate the impact of oil shocks, we estimate a Bayesian VAR model with global growth, global inflation, oil prices and the VIX index. The estimated reaction of global GDP growth to a 15 per cent decline in oil prices suggests that global growth gains by 0.2-0.3pp in the first year following the shock, with 70 per cent of the simulations falling in a range of 0.1 to 0.5pp,” explained the Global Economics team at BofA Merrill Lynch.

The oil price drop pulls global inflation down by 0.1pp in the first year after the shock, according to the model. It is hard to establish how quickly the shock fades, but on the whole this estimate is smaller than suggested by other exercises. With global inflation hovering just under 2 per cent, this would still be enough to push inflation down to the lowest level since the crisis.

Winners and… runners up

As a large net oil importer, Asia stands to gain from cheaper oil. As Emerging Asia economists Hak Bin Chua and Marcella Chow note, Korea, Thailand, India and Taiwan will probably see the biggest GDP benefits.

Mexico and Colombia would lose from lower oil prices. “Our EEMEA team contrasts the hit to Russia and the GCC economies against the gains accrued by Turkey and CEE countries,” said the BofA Merrill Lynch Global Research report.


In developed markets (DM), the largest economies are likely to profit from cheaper oil.

“Our US team thinks that, despite the adverse effect on the energy sector, the net impact of oil price drops remains positive. In Japan, however, Masa Kichikawa highlights that the impact on the Japanese economy will likely be offset by the weaker yen. All told, the estimated impact of the recent drop in oil prices seems meaningful,” said the research team at BofA Merrill Lynch.

The risks are skewed towards a smaller-than-estimated effect, however. For some economies, oil price declines may have less of an effect than comparable increases. And the boost may be tamed by the current growth headwinds. At any rate, the US, Europe and much of Asia will likely rank amongst the big winners, noted the BofA Merrill Lynch Global Research report. – TradeArabia News Service




Tags: Brent |

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