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Relationship between Oil, Growth and Employment

Shrinking of (and the rising irrelevance of) the energy sector will mean slower global growth and fewer employment opportunities

So from the mid-forties, oil is back at $68. This is slightly above the estimated level at which dormant shale capacities become viable again. Mind you, at least US shale oil production has not yet started slowing down, although inventory stockpiles have shown a small downtick - not enough to justify a 40 per cent pullback.

So what happened to all that talk about the death of oil and its future irrelevance to both global economics and global geopolitics. As Mark Twain might say, it looks like the reports of the demise of oil were greatly exaggerated.

Now is that good news or bad news? We still don't know what to think. At first, we thought that oil price deflation helped consumption, and the US, being a consuming economy, would see higher growth. Instead, we found that people used the savings in oil to pay down debt or stuffed the savings into their mattresses. On the other hand, fully 35-40 per cent of the capex in the US economy was coming from shale oil investments, which slowed down (and might even reverse this coming year), so nobody still knows whether dropping oil prices were a bane or a boon. What we do know is that next year this capex is not going to be renewed, even if oil crosses $75 because nobody is going to trust that oil will stay up.

Forty per cent of the total jobs generated in the US since 2008 have been in Texas, most of which have come from the booming shale oil sector. The other big job generator has been Bakken Oil Fields in the North Midwest. If you strip out the jobs created by the shale oil sector, the US does little better (about 5 per cent cumulatively) than Europe. Similarly, wage growth is tepid to start with but disappears altogether if you strip out the jobs added in the shale oil sector.

So did falling oil prices really help global growth this year or not? Look at India, another so-called pure play on falling oil prices. It would seem most of the oil savings went into deleveraging. Neither did it result in an immediate uptick in consumption, nor did the deleveraging result in an upturn in the investment cycle.

A look at just the US and India, those two beacons of high economic growth, would tell you (anecdotally) that falling oil prices have been used by stressed consumers to deleverage. You think Europe and Japan, those other two major importers, would have seen ebullient customers?

Deleveraging is a long, slow process, and sentiment changes slowly, as the Modi government is realising. It is like a hangover; you don't come out of it immediately. Companies use cash flows to retire debt, improve balance sheets and then they wait for banks to change sentiment. For a long time, deposit growth runs ahead of credit growth (which is happening in India just now), before banks come back to aggressive lending. Governments try to help, especially in controlled economies (like India), by mandating public sector banks to increase lending to kick-start the return to good times. But as we can see in China, this is often fraught with danger because it can lead to a massive misallocation of capital, even derailing a recovery.

So in the short run, most of the job creation (and wage growth, such as it is) has come from the shale oil sector, linking all the good news in oil, economic growth and employment to each other. It is not necessary that these linkages will remain, as the US recovery needs to develop new legs before it can pull itself out of the balance sheet recession it finds itself in.

That is how things are, but what do things look like in the near-term future? Well, the market knows everything, and it would have figured that shale oil capex will slow down, if not outright collapse as the sector becomes a victim of its own success. Saudi Arabia has played it brilliantly by showing the shale oil producers just how low it can allow oil prices to go without flinching. No strategic planning head in any shale oil company is going to clear capex that does not stand up to stress testing at, say, $35 per barrel. Yes, these (shale oil) companies are innovative, and the cost curve keeps coming down, but you do not incur significant capex in the belief that you will bring the cost down by 50 per cent. And even if the company is foolhardy enough to jump, it is unlikely to find bankers to bankroll the capex, especially in an era of rising interest rates. Already, risk premiums for oil capex have risen to the point where almost all the bond issuances from the sector are in the high-yield segment.

So whatever capex was coming from shale oil and the resultant jobs growth are going to slow down, may even collapse. That means that oil will rise, maybe, but it won't fall too much. I would think about $50 as the bottom, but the top cannot be predicted. One should look for those bank analysts who predicted oil at $20.

But volatile it will remain, creating a reasonable amount of trouble. In the long run, (say, ten years) oil will become irrelevant to global growth. It's been just about ten years when it was said about oil that a $10 rise in the price of oil lops off about 0.5 per cent from global growth. Today oil has just risen about $20 dollars, and there is not even the whisper of it slowing down global growth. In another ten years, believe me, it won't just be oil which will be irrelevant; even energy costs will not make such a dent in global growth prospects.

As oil stabilises in rather a wide range of, say, $50-80, the next wave of disruption is already round the corner, and it will start as solar energy reaches grid parity with coal/thermal energy across the world. That will start a sharp rise in solar energy use, cutting into the share of thermal power generation, with renewable energy taking market share from fossil fuels. This will affect mining as a whole. All this will have severe deflationary effects on prices in general, leading to further personal and corporate deleveraging.

India's medium-term prospects are encouraging, both as a solar producer and an oil importer. If gold imports are kept under control, our current account deficit should be low and easily funded, and the only pressure on the rupee will be from competitive devaluation.

Coming back to the relationship between oil, global growth and employment, the point made above is that this is getting a little more tenuous. The shrinking of (and the rising irrelevance of) the energy sector will mean slower global growth and fewer employment opportunities. Consum-ption will rise very slowly as older borrowers will be slow to borrow again... Some of the really old borrowers may never come back as borrowers. It is the countries with younger populations which will see a rise in leverage.

What does all this mean for interest rates? I doubt there is enough traction in the world economy to allow for a steep interest rate curve. There is enough deflationary pressure coming from oil, as the cost curve of the shale oil producers keeps falling.

I doubt there is enough growth momentum left in the global economy to justify any serious rate hikes. If inflation stays low and poor growth momentum ensures that real interest rates will have to be kept negative for some time, it follows that zero-bound interest rates will be here for some time to come. If any foolhardy central bank does any premature tightening, it will follow that it will be risking a sudden loss of growth momentum. Not only will it see a disproportionate hardening of its currency (which in turn will lead to an increase in the CAD, reducing net growth) but it will also slow down domestic growth.

The author teaches, trades and writes at spandiya.blogspot.com.

This column appeared in the June 2015 issue of Wealth Insight.