Business Irish

Tuesday 26 September 2017

How lower energy costs can fuel a recovery in domestic economy

If low energy prices can be sustained, the cost base for business will come down and households will find themselves with more disposable income, writes George Garvey

As recently as late March, Brent crude was trading at over $125 (€98) a barrel. By earlier this week crude oil prices had fallen to under $96 a barrel, a 23pc fall in dollar terms.

Even when the recent fall in the value of the euro against the dollar is taken into account, from $1.33 to $1.26, oil prices have still fallen by 19pc from €94 to €76 in euro terms.

And it's not just oil prices. Bord Gais Energy compiles an index of Irish energy prices, oil, natural gas, electricity and coal. After hitting a record high of 157 in February the index had dropped to 142 by May, a fall of almost 10pc.

Bord Gais also calculates that other energy prices have also fallen from their February peak with the price of natural gas, from which most Irish electricity is generated, down by 8pc, electricity was down 7pc while coal prices were down by over 2pc.

Energy prices on the international commodity markets have major implications for Ireland which has relatively sparse supplies of domestic energy.

Ireland imports approximately 96pc of the energy it consumes. We have by far the highest dependence on imported energy of any eurozone country, with the average across the single currency area being 69pc.

Oil is by far the most significant source of energy consumed in Ireland, with a 64pc share. This compares to a eurozone average of just under 44pc.

Natural gas, the price of which generally moves in line with that of crude oil, accounts for about another 23pc of Irish energy consumption.

With no nuclear energy, this leaves Ireland far more dependent on imported fossil fuels than most other European countries.

However, while Ireland might be uniquely dependent on imported energy, particularly fossil fuels, the energy intensity of the Irish economy -- the amount of energy which we consume to produce every unit of output -- is the second lowest in Europe after Malta.

Ireland's energy intensity is only two-thirds of the eurozone average.

While the low energy intensity of the Irish economy may be largely due to historical factors, -- this country industrialised late and thus has no legacy of steel mills or other energy-intensive heavy industry -- it is a fact that is often overlooked when considering the Irish energy market.

Low energy intensity or not, the fact remains that our extremely high dependence on imported energy leaves us extremely vulnerable to sudden spikes in oil and gas prices.

Matters aren't helped by the extremely open nature of our economy and our remote geographical location. All of those exports and imports have to be transported off or on to the island across one, and sometimes two, sea crossings.

Middle East sanctions

Global oil production is currently running at around 89 million barrels per day. Saudi Arabia, the swing producer which has a disproportionate influence on prices, is currently producing 10 million barrels, its highest production level since 1989, while Libyan and Iraqi production is also running at close to record levels.

As against that, unless Iran agrees to stop enriching uranium, the EU will impose strict new sanctions on the Ayatollahs' regime from the beginning of next month, which is just 10 days away.

These sanctions include not just a ban on the importation of Iranian oil by European countries but also making it impossible for European ships trading with Iran to insure their cargoes.

How will Iran, which derives between 60pc and 70pc of its total income from oil exports, respond to these tough new sanctions? Will it provoke an international incident? If it does oil prices could suddenly shoot higher.

Or will we see a repeat of what happened when sanctions were imposed on Saddam Hussein's Iraq?

If so, experience would suggest that so long as the Tehran government was prepared to sell its oil at a discount, significant quantities of Iranian oil would continue to leak on to the market. Where there's a will there's a way. If the possibility of Iran cutting up rough threatens a sharp upward movement in oil prices, an implosion of the eurozone could have the opposite effect.

The disintegration of the single currency could have very damaging implications for the global economy, at least in the short term, and drag down the demand for oil with it.

Bord Gais oil trader John Heffernan is very much a member of the optimists' club when it comes to oil prices. While acknowledging the possibility of an adverse Iranian reaction, he believes that oil prices are likely to trade within a range of $90 to $110 a barrel for the foreseeable future.

At current levels of global economic activity the supply of, and demand for, oil are finely balanced. With much of the older, more easily extractable fields already exhausted or headed that way, pumping oil from the newly discovered fields, either those offshore of Brazil or the Canadian tar sands, is much more expensive.

In practice, many recently discovered oil fields need prices of $90 a barrel or more if they are to remain viable.

OPEC, the oil producers' cartel, is also targeting a price of around $100. If prices drop much below that level, it turns off the taps. If they go much above $100 it increases production.

At the same time, there is clear evidence that once oil prices go above a certain level, they have a disproportionate impact on demand.

This is what happened in July 2008 when oil prices briefly touched $147 a barrel.

At these elevated prices motorists drive much less, householders cut back drastically on their heating and electricity usage, companies consume less energy and prices can suddenly fall very rapidly.

The events of the second half of 2008 show what can happen when oil prices go too high. By December of that year oil prices had fallen as low as $38 a barrel, a 74pc drop in just over five months.

With the Chinese economy rapidly slowing and the euro threatening to fall apart what are the chances of that happening once again? Irish motorists and householders certainly wouldn't complain if it did.

What is clear is that a fall in energy prices would act as a stimulus for the chronically depressed domestic economy.

Money which had previously been going on imported energy would instead be available to be spent on other goods and services. Households would see their disposable incomes rise while businesses would see their costs fall.

IBEC chief economist Fergal O'Brien has done some calculations on the likely impact of a fall in energy prices on household budgets.

Extrapolating from the CSO's 2009/10 Household Budget Survey he estimates that the average working household will spend almost €6,000 on energy in 2012.

This will be split between €2,558 spent on fuel and light and €3,229 on motor fuel. If energy costs were to fall back to 2010 levels, the amount spent on fuel and light would be reduced by €482 to €2,076, while the amount spent on motor fuel would be reduced by €608 to €2,621.

That's a total of €1,090 added to the disposable income of the average working household, the equivalent of almost 2pc of the post-tax income of a mortgaged household and 2.4pc of the post-tax income of a non-mortgaged household.

"You would see a significant impact from lower energy prices at a number of levels," says Mr O'Brien.

"As a result of higher energy prices, a lot of money has been coming out of consumer spending and household budgets in recent years.

"If some of that was reversed there would be a big boost to spending power, particularly if mortgage rates fell also. Households would suddenly notice quite a lift in their disposable incomes".

And it isn't just households that would benefit from lower energy costs.

"High energy costs are a very significant issue for a whole range of businesses. It is one of the biggest cost concerns for manufacturing, food and drink, and distribution.

"We suffer disproportionately from a competitiveness point of view with higher fuel prices", he said.

David Duffy, co-author of the ESRI's Quarterly Economic Commentary also believes that lower energy prices would deliver a boost to the economy:

"If energy prices came down and stayed down it would lower the rate of inflation. It would also reduce the cost of car journeys and have a small effect on disposable incomes. Lower energy prices would also impact on the cost base for business, particularly those with large energy and transport components."

Energy prices have been extraordinarily volatile over the past five years. Crude oil prices soared in mid-2008, then collapsed and subsequently regained most of their losses between 2009 and 2011 only to fall again this spring.

Is the current drop in prices for keeps or is it merely the latest whirl of the roller coaster? Hard-pressed Irish households and businesses will be desperately hoping that the Ayatollahs don't do anything daft and that this time energy prices stay down.

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