Crude Oil Price Plunge and the Japanese Economy

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1 ECONOMIC REPORT 2015 SUMMER Crude Oil Price Plunge and the Japanese Economy As a result of the steep fall in the crude oil price since the second half of last year, the burden of the high level of payments made by Japan to foreign countries, which has continued to weigh heavily on the Japanese economy, has eased substantially. The decline in payments to foreign countries provides a tailwind that will lift the Japanese economy by stimulating domestic consumption and investment in due course. However, in a longer term, the crude oil price is likely to rebound sooner or later, as energy demand is expected to grow in line with the high growth of emerging countries. Crude Oil Price Plunge The crude oil price fell steeply in the second half of 2014 and early this year. Although the crude oil price has rebounded slightly since then, the average price in the first half of 2015 was $51.2/barrel, down 45.1% from the average for the whole of 2014 ($93.2/barrel). The current level of around $50/barrel is the lowest in 10 years except for a brief period around the time of the collapse of Lehman Brothers that triggered the global financial crisis, as shown in Figure Looking back at the effects of crude oil price movements in the past, the Japanese economy has been rocked violently by price swings. In the case of the two oil crises one in the first half of the 1970s and the other in the first half of the 1980s that were triggered by wars in the Middle East, the price hikes that OPEC implemented while threatening to restrict supply caused significant inflation and slowdown in economic growth. $/barrel First oil crisis Figure 1 The level of the crude oil price and year-on-year changes Second oil crisis Price plunge in 1986 Year-on-year change (right axis) June 2008 Level % June 2015 June Year Source: Wall Street Journal

2 In 1986, the crude oil price plunged from the $30 range to the $10 range as a result of an increase in supply from the North Sea Oil fields off the United Kingdom and Norway. The crude oil price drop at that time, coupled with the effects of the yen s appreciation, had a huge impact, bringing an unexpected increase in income (growth in national wealth) to the Japanese economy. However, this boon, which arrived at a time when Japanese companies export competitiveness was strong, bred overconfidence in the real economy and fueled excessive expectations for stock and land price rises, putting Japan on the path to a crisis to be touched off by the bursting of economic bubbles *1. Meanwhile, the upsurge in the crude oil price in the 2000s caused Japan to lose a vast amount of national wealth, just as companies facing a steep increase in input prices while output prices are not rising much would suffer from a financial squeeze. This was a major cause of Japan s economic stagnation and deflation *2. Cause of the Crude Oil Price Plunge The greatest cause of the steep fall in the crude oil price since the second half of 2014 is the start of full-fledged production of shale oil in the United States and the ensuing increase in supply, as indicated in Figure Figure 2 Major supplier and consumer regions and the global supply-demand gap rate Million barrels/day % IEA forecast Global net supply-demand gap rate (%, right axis) Net demand in North America Net demand in Europe Notes: 1 While the IEA does not provide forecasts for the volume of supply from the OPEC region, it is assumed that the volume will remain flat because of OPEC s decision to keep the production quota unchanged at general meetings in December 2014 and June The supply-demand gap rate = (global volume of crude oil demand - global volume of crude oil supply) global volume of crude oil demand x 100 Source: International Energy Agency Trend line over the six years from 2009 to 2014 Supply-demand condition tightening: price rise Supply-demand condition easing: price decline Net demand in OPEC Net demand in Asia/Oceania excl. China Net demand in China 2

3 Figure 2 shows net demand for crude oil (left axis) by major consumer and supplier regions. Asia and Oceania excluding China, which includes Japan and Southeast Asian countries, has the largest net demand, which represents total demand minus total s upply, followed by Europe, China and North America (mainly the United States), in that order. OPEC has continued to serve as the largest supplier, with its supply equivalent to around 30% of the global demand. Net demand in North America has shown the most volatile movements recently. Over a period of around three years from the July-September quarter of 2011 to the January-March quarter of 2015, net demand in North America halved, from 10.3 million barrels/day to 4.7 million barrels/day (down 5.6 million barrels/day). This was caused by a steep increase in shale oil supply. Over the same period, net demand in the OPEC region declined by a smaller margin (down 1.6 million barrels/day). Consequently, the supply-demand gap rate (represented by the red bar graph), which was in the plus column until the January-March quarter of 2014, fell to minus 1.9% in the October-December quarter. The supply-demand gap rate is calculated by dividing the global net demand, or global demand minus global supply, by the global demand. When the supply-demand gap rate is in the plus column and is rising, it signals tightening of the supply-demand condition of crude oil and upward pressure on the crude oil price, and when the rate is in the minus column and dropping, it means possible easing of the supply-demand balance and downward price pressure. The expansion of the negative supply-demand rate is the most significant cause of the steep fall in the crude oil price since the second half of Variable Factors of the Crude Oil Price and the Future Outlook As a definitive theory as to what factors move the crude oil price does not exist, it is generally believed that it is not easy to forecast future price movements. However, examining the supply-demand gap rate not only facilitates understanding of variable factors of the crude oil price but also makes it possible to provide a broad estimate of price movements in the months ahead. Figure 3 provides a comparison of movements in the supply-demand gap rate and the crude oil price. In many cases, when the supply-demand gap rate expanded, indicating a tightening of the supply-demand condition, the crude oil price rose after a certain time lag. When the supply-demand gap rate declined, indicating an easing of the supply-demand balance, the crude oil price dropped after a certain time lag. 3

4 Although the supply-demand gap rate has recently been negative, the negative gap has been shrinking rapidly since the minus 1.9% recorded in the October-December quarter of The shrinkage of the negative gap stemmed from stepped-up production cutbacks by U.S. shale oil suppliers suffering deterioration in profitability due to the sharp drop in the crude oil price (the production index for the U.S. oil drilling industry has recently stayed at a level around 40-50% lower than the previous year s level). However, from these data alone, it is unclear how much time lag there is between a change in the supply-demand gap rate and a change in the crude oil price and how much of an impact a change in the gap rate has on the price. Therefore, I statistically calculated the time lag period when these two factors are most closely related with each other. As a result, it was found that the crude oil price was most closely related with the supply-demand gap of three quarters before *3. Figure 3 Relationship between the crude oil supply-demand Figure 4 Future trend in the crude oil price gap rate and the crude oil price estimated from the crude oil supply demand gap rates be Supply-demand gap rate (Note 1) Crude oil price (right axis) % Supply-demand condition tightening Supply-demand condition easing $/barrel IEA Forecast Crude oil price $/barrel (Note 3) Estimated crude oil price Forecast by the author Correlation coefficient (Note 1) Notes: 1. The correlation coefficient indicates the degree of closeness of the relationship between two indicators. Generally, a coefficient of 0.8 or higher is deemed to indicate a strong positive correlation, a coefficient of 0.6 to 0.8 is deemed to indicate a positive correlation, a coefficient of 0.4 to 0.6 is deemed to indicate a weak positive correlation and a coefficient of 0 to 0.4 is deemed to indicate a lack of correlation. 2. Estimated crude oil price in Figure 4 = x supply-demand gap rate of three quarters before Source: International Energy Agency, Wall Street Journal Figure 4 shows the estimated trend in the crude oil price calculated through the relative equation (regression equation) that is applicable when the time lag is three quarters. This estimation is possible because the International Energy Agency (IEA) published a demand forecast by region for a year ahead. The use of this forecast enables the estimation of crude oil price movements over the coming one year and three quarters (until the July-September quarter of 2016) Correlation coefficient (Note 2) According to the estimation, the crude oil price will rebound after hitting a low of 4

5 $50/barrel in the July-September quarter of 2015 and will reach $68/barrel in the July-September quarter of 2016 (annual average of $57/barrel in fiscal 2015 and $61/barrel in 2016). However, the past relationship between the supply-demand gap and the price shows that the crude oil price may deviate significantly from the estimated figures, so the price could temporarily plummet to as low as $30 or $40/barrel due to excessive sales by speculative traders. Conversely, if the crude oil price starts to rise, it could temporarily climb to as high as around $80/barrel. Economic Boon from the Crude Oil Price Plunge A fall in the crude oil price will bring favorable economic effects in due course. However, it will take about one year before the effects become clearly visible. That is because past experience shows that it takes around a quarter before prices of non -durable goods decline following a drop in the crude oil price and around three quarters before actual consumption of such goods increases following the drop in their prices. Furthermore, it takes around six months before the effects of the increased consumption spread to capital investment *4. Therefore, it will probably not be until this autumn when the effects of the drop in the crude oil price will actually be felt by the people. How significant will those effects be? If we assume that the crude oil price will stay at the current level of $60/barrel, that will mean a decline of 39.1% in the average price in 2015 compared with the previous year. Since crude oil accounts for around 24% of the overall value of nominal imports, the nominal value of imports will fall 9.4% ( 39.1% 24%) in As nominal imports account for around 21% of nominal GDP, the decline in the value of nominal imports will raise nominal GDP by 2.0% ( 9.4% 21%). This positive cycle of diminishing but perpetual effects will continue as follows. People who gain additional income due to increased nominal GDP will increase their consumption. If we assume the ratio of consumption to income (consumption propensity) is 60%, nominal GDP will grow by an additional 1.2% ( 2.0% 60%). The 1.2% increase in nominal GDP will lead to an increase in consumption, which in turn will raise nominal GDP by 0.7% ( 1.2% 60%). In short, if the crude oil price stays at around $60/barrel over the coming years, nominal GDP will get a 2.0% boost in the first year, to be followed by booster effects of 1.2%, 0.7%, 0.3%, 0.2% and 0.1% in subsequent years, for total effects equivalent to additional growth of around 5% in 5

6 nominal GDP. This is no small figure given that the average growth of Japan s nominal GDP was 1.5% over the past five years and 0.6% over the past 10 years *5. Below, I will estimate future movements of the mining and industrial production index and the consumer price index on the assumption of the abovementioned annual growth in nominal GDP (the core CPI, which excludes energy and food prices). Figure 5 shows an estimated trend in the mining and industrial production index calculated on the basis of the assumed annual growth in nominal GDP in light of the past relationship between these two factors. Until now, the mining and industrial production index followed the nominal GDP trend without any time lag. Consequently, if it is assumed that nominal GDP grows 1.8% in 2015, 1.7% in 2016 and 1.0% in 2017 compared with the previous year, the mining and production index is estimated to grow 2.3% in 2015, 3.8% in 2016 and 2.2% in Figure 5 Forecasts of nominal GDP and the mining Figure 6 Forecasts of nominal GDP and and industrial production index (Note 1) the consumer price index Nominal GDP Mining and industrial production index (right axis) Trillion yen 2010= Forecast 115 (Note 2) Notes: 1. Mining and industrial production index = nominal GDP of the current year x fixed value: (t-value: 11.2) (t-value: 6.1) Correlation coefficient: Measurement period: From the January-March quarter of 2002 to the October-December quarter of Core core CPI = nominal GDP of five quarters before x fixed value: (t-value: 10.1) (t-value: 9.5) Correlation coefficient: Measurement period: From the January-March quarter of 2002 to the October-December quarter of 2014 Source: Cabinet Office, Ministry of Economy, Trade and Industry Source: Cabinet Office, Ministry of Internal Affairs and Communications Figure 6 shows an estimated future trend in the consumer price index calculated in light of its past relationship with nominal GDP. In the past, the consumer price index followed the nominal GDP trend with a time lag of five quarters. This time lag occurs because even if corporate earnings increase due to nominal GDP growth, wages remain almost flat until the annual wage revision in the spring of the following year. On the Nominal GDP Trillion yen Core core CPI (right axis) 2010= Forecast

7 assumption of the abovementioned assumed growth in nominal GDP, the consumer price index is estimated to rise 0.2% in 2015, 0.8% in 2016 and 1.0% in Future Challenges As explained above, the Japanese economy is getting a tailwind for the first time in a long time thanks to the crude oil price plunge. However, we cannot welcome this situation with open arms. An excessive price fall is likely to be followed by a rebound sooner or later, so if companies become complacent, they could be negatively affected. As was already mentioned, U.S. shale oil producers are sharply cutting back on their production. If emerging countries, most of which are net crude oil consumers, record high economic growth, the supply-demand condition will become tight. Japanese companies should avoid falling under the delusion that this positive turnaround, which is a bonanza brought by the crude oil price plunge, is a product of their own efforts. Rather, they should continue efforts to reduce energy use and create new energy sources and should pursue innovation activities that have been difficult during the period of economic stagnation. I hope that many companies will take on the challenge of carrying out management reforms that will enable them to sustain such efforts. *1 For further details, see Economy Watching 106 (January 19, 2015, 3. Cause and Effects of the Crude Oil Price Plunge ), which is available in Japanese at the website below. *2 For further details, see FINANCIAL FORUM SUMMER 105 The Japanese Economy s Achilles Heel, which is available at *3 The crude oil price is most closely related to the supply-demand gap rate of three quarters before as shown below: Time lag between the price and gap rate Correlation coefficient None (the same quarter) quarter quarters quarters quarters *4 For further details, see Economy Watching 109 (April 21, Crude Oil Price Plunge and the Generation of Bubbles ), which is available in Japanese at the website indicated in *1. *5 The dollar-denominated crude oil price, rather than the yen-denominated one, was used in this analysis because using it is better when the amounts of imports and exports are similar. Haruhiko Murayama General Manager, Tokyo Economic Research Division 7

8 Kyoto Research Institute, Inc. FINANCIAL FORUM 2015.SUMMER No109 The purpose of this report is to provide information, not to solicit the buying or selling of investment products. Information included in this report comes from sources regarded as reliable by the Kyoto Research Institute, Inc. However, the Kyoto Research Institute, Inc. makes no guarantees as to the accuracy and completeness of the information. Customers themselves are responsible for making final investment decisions. 8

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