3 – The impact of lower oil prices on the UK economy · PDF file3 – The impact of...

UK Economic Outlook March 2015

3 – The impact of lower oil prices on the UK economy

Key points• Thesignificantfallinoilprices sincemid-2014shouldincreaseoverallUKeconomicactivityas the cost of production decreases for businesses,especiallyforthosethatareheavilydependentonoilinputs.Thiswillboostbothinvestment andemployment.

• Although the oil and gas extraction sectorisnegativelyaffectedbythereduction in the oil price, sectors such as agriculture, air transport, cokeandrefinedpetroleummanufacturingandoil-intensivemanufacturingsectorswillbenefit asthepriceoftheirkeyinputfalls.

• Water transport and other services sectorswillenjoyasmallpositiveimpact.However,oil-intensivesectorsarelikelytobenefitfrom the reallocation of capital and resources at the expense of less oil-intensivesectors.

• WeuseamodeloftheUKeconomytoquantifytheseeffectsinthreealternativescenarios.Inacasewherethe reduction in the oil price is permanent, settling at around $50perbarrel,thesizeoftheUKeconomy(GDP)increasesbyaround1% on average relative to the baselinebetween2015and2020.Employmentalsoincreasesbyaround90,000by2020,withapeakboosttoemploymentofaround120,000in2016.

• Incontrast,theimpactsaresmallerwhere the fall in the oil price is temporary:dependingonhow farandfastoilpricesrebound, theboosttoGDPcouldvary from0.2-0.5%andtheincrease inemploymentby2020could varyfrom3,000to37,000.

• Real household incomes also rise as oil prices fall, which increases consumer spending. This is due to two factors: overall consumer prices fall as cost savings are passed on to households and real wages increase asdemandforlabourrisesinfast-expandingsectors.

• As a result of growing economic activity,governmenttaxrevenuesalso rise as the tax take from corporate and personal income taxes increase, more than offsetting declining revenues from the oil and gas sector. The fall in the oil price should also have a small impact in narrowingtheUKtradedeficit.

IntroductionThe dramatic decline in oil prices since mid-2014ishavingasignificantimpactontheworldeconomy.Howdoessuch a large and unexpected decline in oil pricesaffecttheUKeconomyspecifically,andwhichindustrysectorsarelikelytoemergeaswinnersorlosers? How does a change in the oil price affect UK government revenues andthetradebalance?

Inordertoanswerthesequestions, weusedourdynamiccomputablegeneralequilibrium(CGE)modeltoassess the impact of future changes intheoilpriceontheUKeconomy. Weusedthreeprojectedoilpricescenarios that differ in the magnitude and persistence of the oil price shock, againstabaselinewhereoilpricesremainatmid-2014peaklevels.

The rest of the article is structured as follows:

• Section 3.1 discusses past trends in oil prices and the UK’s trade position in crude oil and oil products.

• Section 3.2 sets out our oil price scenarios and modelling approach.

• Section 3.3 discusses the results fromtheanalysis.

• Section3.4summarisesanddrawsconclusionsfromtheanalysis.

The significant fall in oil prices since mid-2014 should increase UK economic activity.


3.1 Trends in oil prices and the UK’s positionTrends in oil prices

OilpricesmostlytradedabovetheUS$100/barrelmarkoverthefouryearstomid-2014.However,bymid-January2015,oilpriceshadfallendramaticallyto around a third of their peak level in June2014and,despitesomerecoverysincemid-January,remainwellbelowthose levels. The recent fall in oil prices wasoneofthebiggestinhistory,withtheonlycomparabledeclinesinrecentdecadesbeingtheoilpricecollapseinthe1980sandinthe2008-9globalfinancialcrisis.Thelatterwasreversedrelativelyquickly,buttheformerprovedtobelong-lasting,soweneedtoexplorehow different scenarios for future oil pricemovementswillinfluencetheeconomic impact of the recent decline.

Acombinationofsupply-anddemand-side factors led to this sharp decline. Onthesupply-side,stronggrowthinproductionbynon-OPECproducers and growing US shale oil production havecontributedtoanoverallincreasein output. Added to this is the apparent strategyofOPECproducersledbySaudiArabia(whohavelowerproduction

costs)tomaintainproductionlevels in order to defend and grow market sharebyforcingmoreexpensiveunconventional sources out of the market.Onthedemand-side,thedecelerating pace of growth in China andthesloweconomicrecoveryin theEUhavecontributedtoweakeningdemand for oil.

Thesefactorscombinedhaveexerteddownwardpressureonprices.Inaddition,oil consumers are taking advantage of theopportunitytostockpilecheapoil,which could further dampen demand foroilintheshort-term.

Inthelongerterm,technologicaladvancements will continue to drive down the costs of extracting unconventional shale gas and tight oilreserves(includinghydraulicfracturingor“fracking”methods),whichwillbolsternon-OPECoilsupply.Furthermore,therebalancingoftheChineseeconomyawayfrommanufacturing to services could have a negative impact on oil consumption.1 Growthinotherdevelopingcountries,increasingenergyefficiencyandtheshifttowardsrenewableenergyindeveloped countries could mean that

Figure 3.1: UK net exports of crude oil and oil products2

Source: DECC

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Crude oil Oil products

demandforoilisincreasinglydriven bydevelopingcountriesratherthandeveloped countries.

The net impact of these factors is unclear, butcouldimplyareturninthelongerterm to a level of oil prices in line with marginalsupplycosts,whichatcurrentandprojectedlevelsofglobaldemandmightbearound$70-100perbarrel. Thepathbywhichpricesreturntothiskindoflevelis,however,highlyuncertain,asisthepaceofanysuchadjustment.

The UK’s position

The UK is the largest producer of oil andsecond-largestproducerofnaturalgasintheEuropeanUnion.ProductionfromUKoilandnaturalgasfieldsintheNorthSeapeakedaroundthelate1990sandhasdeclinedsteadilysinceasthediscoveryofnewreservesandnewproduction has failed to keep up with thematurityofexistingsites.Figure3.1shows the UK’s position in terms of net exports of crude oil and oil products. Followingyearsofbeinganetexporterof petroleum and natural gas, the UK becameanetimporterofcrudeoilfrom2005,andoilproductsfrom2013.

1 IMF(2013)“CommodityMarketReview”,October2013.2 Crudeoilincludestheproductionofcrudeoilandnaturalgasliquids,petroleumproductsarerefinedcrudeoil.Anegativevaluesignifiesthatinthatparticularyear

imports were greater than exports.


Figure3.2comparesthehistoricrealgrowthinGVAfortheUKoilandgassectorandfortherestoftheeconomy.Theoilandgas sector – which consists of the extraction of crude petroleum and natural gas and the manufactureofrefinedpetroleumproducts– has shrunk to around a third of its size sinceitspeakinthelate1990s.Thesectornow accounts for less than 2% of total UK GVA,ascomparedto6%in1999.

3.2 Modelling the impact of oil price shocks on the UK economyOur modelling approach

Weusedacomputablegeneralequilibrium(CGE)modeltoassesstheimpactoffuturechangesintheoilpriceontheUKeconomyin three alternative scenarios. The model estimateshowtheUKeconomywouldreacttochangesinpolicy,technologyandotherexternalfactorsbylookingattheinteractionsbetweendifferentindustrialsectors, households, the government and the rest of the world. These models are a standard tool of empirical economic analysis,andarewidelyrecognisedandusedbyinternationalorganisationssuchastheIMF,OECDandtheWorldBank,as well as the European Commission, nationalgovernmentsandcentralbanks.

We simulate an oil price shock in this modelbyreducingtheoutputpriceoftheoil and gas extraction sector and the input priceofothersectorsintheeconomy,which takes into account the relative oil intensityofthedifferentsectors.

Oil price scenarios

We assess the following three scenariosfortheperiodto2020(showninFigure3.3):

Figure 3.2: Real GVA growth for oil and gas sector vs rest of UK economy

Source: ONS

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Oil and gas sector GVA excl oil and gas

Rest of economy

Oil and gas

Figure 3.3: Alternative oil price scenarios

Source: PwC analysis, IMF

Baseline

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Scenario 2

Scenario 1US$/

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Scenario 1 Scenario 2 Scenario 3

• Scenario 1: Oil price remains atalowlevelofUS$50/barrel.

• Scenario 2:OilpricegraduallyincreasestoUS$73/barrelin2020.3

• Scenario 3:OilpricegraduallyreturnstoUS$108/barrelin2020.

TheCGEmodelmeasurestheimpactofeachscenariorelativetoabaseline

3 TheforecastsforScenario2weredrawnfromtheIMF’sprojectionspublishedinJanuary2015.ThisscenarioisalsobroadlyconsistentwithourmainscenariofortheUKeconomyinSection2above.


Figure 3.4: Impact on the level of real GDP, 2015-2020

Source: PwC analysis

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where the oil price remains at its mid-2014peakofaround$108perbarrel.ThisbaselineisalsoconsistentwithourgrowthprojectionsfortheUKeconomypublishedintheJuly2014issue of the UK Economic Outlook. Themodelalsoassumeslonger-term UKeconomicgrowthtobeinlinewithhistorical trend growth rates.

3.3 Results from our analysisThe results from the modelling show thattheUKeconomywillbesignificantlyaffectedbyareduction inoilprices.AlthoughNorthSeaoilproducersandrefinerswillexperience areductioninoutput,theUKeconomybenefitsasawhole.Generally,thefall in oil prices increases overall economic activityasthecostofproductiondecreases and investment increases. Consumersalsobenefitfromlowerenergycostsandcheapergoodsandservices,whichboostsrealincomes and translates into an increase in consumption. Below we present and discuss these results in more detail.

Impact on overall UK GDP

Figure3.4showstheimpactofthechange in oil price on the level of UK realGDP.4AsshowninFigure3.4, in Scenario 1, where the oil price remainspersistentlylowatUS$50 perbarrelbetween2015and2020, the initial impact will raise the level of realUKGDPbyaround1.2%inthefirstyearrelativetothebaselinewhereoilpricesremainedat$108perbarrel. Theeffectpeaksin2016whenthelevelofGDPincreasesbyaround1.4%ofthebaselinelevelasthefullimpactoftheoilpriceshockfiltersthroughtheeconomy.Theimpactthentailsofftoaround0.6%ofthebaselineastheUKisexposedtostrongercompetitionbycheaperimports

fromothercountriesthatalsobenefitfrom the oil price shocks, thus diminishingthebenefittotheUK.

InScenario2wheretheoilpricerecoversgraduallyto$73by2020inlinewithlatestIMFprojections,UKGDPisestimatedtobearound0.5%higheronaverageoverthe2015-20periodrelativetothebaseline.

InScenario3,wheretheoilpricerecoverstomid-2014levelsby2020, theimpactontheeconomyismuchsmallerat0.2%onaverageoverthe2015-20period,withminimaleffectsonthelevelofGDPby2020giventhisisapurelytemporaryshockinthisscenario.

The model assumes adaptive expectations, which means that economic agents revise their expectations of future oil prices during eachperiodbasedoncurrentoilprices.The implication of this assumption is thatthereisalagbetweentheinitial oilpriceshockandthesubsequenteconomic impact. The stickiness of downwardpriceadjustmentsalsomeans

that the impact of the oil price shock takestimetofilterthroughtheeconomy.

Inthefollowingsub-sections,wesetouttherestofthefindingsfromouranalysis,particularlywithregardtosectoralGVAandemployment,inflation,householdconsumption, UK government revenues andthetradebalance.

Impact on output by industry sector

Figure3.5mapsthetransmissionofafallintheoilpriceattheindustrysectorlevel.Wedistinguishbetweentheoil and gas extraction sector, sectors with oil-intensiveproductionprocesses, and sectors that use oil and gas less intensivelyintheirproductionprocesses.Ouranalysisfocusesontheimpactofthefall in the oil price on the UK as a whole, ratherthanfocusingonspecificregionswithintheUK.However,therearelikelytoberegionaldifferences,dependingonthedistributionofoil-intensiveindustriesacross the regions.5

TheCGEmodeltakesintoaccountthe“reorganisationeffect”,wherefirmsautomaticallyadjusttheirproduction

4 Seethetechnicalappendixforcomparisonsoftheresultsofourstudywithexistingacademicliterature.5 Inparticular,theareaaroundAberdeenmaybealosergiventheconcentrationofonshoreoilandgasactivitythere.SomepartsoftheNorthandMidlandsmayalsobenefitmorefromimpactsonoil-intensiveheavyindustry,butourmodeldoesnotallowquantificationoftheseregionalvariations.


Figure 3.6: Oil intensity by sector, 2014

Source: ONS

0 5 10 15 20 25 30 35

Proportion of intermediate consumption accounted for by petroleum (%)

Electricity, gas, steam and air conditioning supply

Air transport

Land transport

Agriculture, forestry and fishing

Oil-intensive manufacturing

Water transport

Wholesale and retail trade

Other industry

Other service activities

Construction

Non-oil intensive manufacturing

Financial services and insurance

Figure 3.5: Transmission mechanism of a fall in the oil price

processes in response to changes in input prices, such as wage costs and the cost of intermediate inputs. As the prices of intermediate inputs, such as oil, fall, firmsreorganisetheiractivitiestomakeefficientuseofcheaperinputs,enablingthemtoincreaseoutput.Oil-intensivesectors such as the utilities, transportation,agricultureandoil-intensive manufacturing sectors (seeFigure3.6)arelikelytobenefitmost.Withintheoil-intensivemanufacturing sector, oil and gas-relatedinputsandenergyconsumptionaccountforatleast10% of total intermediate consumption for the following sectors: the manufacture ofrefinedpetroleum,industrialgasesand chemicals, cement and metals.

Oil and Gas SectorSectors with oil intensive

production processes

Sectors that use oil and gasless intensively in their production processes

These sectors experience smaller economic impacts as their oil related cost base falls by less. This means that they have less scope to reduce

prices. They may also experience more competition for scarce resources e.g. skilled

labour or investment so may find it harder to compete with oil intensive industries.

There is generally an increase in aggregate demand in the economy and

these sectors will benefit. They will increase their downstream purchases.

Oil becomes cheaper as an input. Able to reduce prices to increase the demand for their products. If benefits

are not passed on (this happens in some sectors), their profits increase.

Leads to increased investment and greater downstream demand.

Market prices fall and this knocks through to revenues and profits.

Leads to reduced investment and less exploration in the North Sea.

Also purchase less from the downstream supply chain.

Sector Impact Sector Impact Sector Impact

Supply Chain Impact Supply Chain Impact Supply Chain Impact


The model also assumes that workers canmovebetweensectorsastheseexpandorcontract.Ifwagesriseinasectorthatbenefitsfromthefallintheoil price, then we can expect workers to move into this sector to gain from the wage rise. The model also assumes atemporarylossinproductivitytotakeinto account the fact that people need toberetrainedwhenmovingbetweensectors,andconsequently,theirwagesfall during this period.

Table3.1showstheaverageestimatedimpact of the fall in the oil price on the levelofrealGVAbysectorbetweentheyears2015and2020.Averageimpactsare smaller in Scenarios 2 and 3 than in Scenario 1 as in these scenarios the scaleoftheoilpricedeclineisdefined tobesmaller.

As we might expect, the modelling resultssuggestthatsectorswithoil- andenergy-intensiveproductionbenefitmost from a reduction in the oil price. Thesesectorswillbenefitfromlowerproduction costs, and these cost reductionsareassumedtobelargelypassed through to consumers over time which in turn creates increased demand for their products. Higher levels of demand lead to increased investment andimprovedproductivity.Therewillalsobegreaterdemandforexportsandincreased import competition. The increase in overall output also generates more demand for supplier inputs, whichpositivelyaffectsthedownstreamsupplychainviathemultipliereffect.6 Thisiscombinedwithafurtherknock-on impact on aggregate demand as workersemployedwillspendmoreongoodsandservicesintheUKeconomy.

In Scenario 1withpersistentlylowoilprices, the agriculture, air transport,

Table 3.1: Impact on level of real GVA by sector, average for the years 2015-2020


Average % difference from baseline Scenario 1 Scenario 2 Scenario 3

Agriculture, forestry and fishing 2.3% 1.1% 0.3%

Air transport 2.1% 1.0% 0.3%

Manufacture of coke and refined petroleum products

1.6% 0.7% 0.6%

Oil-intensive manufacturing 1.4% 0.6% 0.4%

Other industry 1.4% 0.6% 0.3%

Construction 1.2% 0.6% 0.1%

Non-oil intensive manufacturing 0.9% 0.5% 0.4%

Financial services and insurance 0.7% 0.3% 0.2%


0.7% 0.3% 0.1%

Wholesale and retail trade 0.3% 0.1% 0.0%

Water transport 0.3% 0.1% 0.0%

Land transport 0.2% 0.1% 0.0%

Other service activities 0.0% 0.0% -0.1%

Government -0.1% -0.1% 0.0%

Extraction of crude petroleum and natural gas

-7.9% -4.0% -2.2%

oil-intensivemanufacturingandconstruction sectors all experience an expansioninoutputofaround1-2%ofsectorGVA.Thecokeandrefinedpetroleum manufacturing sector also expandsbyaround1.6%inScenario1.Althoughtheoilintensityofthissectorisrelativelyhigh,theimpactoftheoilprice fall is dampened due to its close linkages with the oil and gas extraction sector,whichisnegativelyaffected.Manufacturingsectorsthatarerelativelyoil-intensiveandenergy-intensive, such as the manufacturing of cement, industrial gases and chemical

products,metals,machineryandequipment and wood products, also experience an increase in output due to the fall in the oil price.

Thebenefitstomanufacturerswouldnotbeuniformlypositiveandareductioninoil prices could generate winners and losers.Forinstance,sectorsthatuselarge volumes of imported materials couldbenefitastransportationcosts fall and overseas suppliers pass on thebenefitstheyobtainfromloweroilprices. However, sectors that operate inexportmarketsmayexperience

6 Theincreaseindemandforsupplierinputsalsoleadstoanincreaseininputprices.


increasedcompetitionfrombusinesseswho can now compete on price in these markets due to lower production and transportation costs.

The role of the transport sector, whether itbebyland,seaorair,willbecriticalindeterminingthescaleofanyeconomicimpacts from oil price reductions. Transport services are critical in facilitating trade within the UK and internationally.Morespecifically,althoughlandtransportisfairlyoil-intensive,itisalsoahighlycompetitivesector. This means that although overall output volumes have increased, the reduction in oil prices could increase the numberofnewentrantstothesector,orforceincumbentstoexpandtheservicestheyoffer,therebysqueezingoverallindustrymargins.

Our modelling also suggests that the construction sector could also gain significantlyfromareductioninthe oilprice.Asbusinessinvestmentrisesfollowing the rise in intermediate demand and consumer spending, we would expect the construction sector tobethekeybeneficiary.Inordertoexpand,businesseswillneedtomovetonew premises, enlarge existing premises orengageinrefurbishment,andtheconstructionsectorwillbetheprimaryprovider of these services.

Thefinancialservicessectorwillexperience a small positive impact on output as it facilitates the reallocation of capital and other resources to the sectors that want to invest in response torisinglevelsofdemand.Ingeneral,oil-intensivesectorsarelikelytobenefitfrom the reallocation of capital and resourcesattheexpenseoflessoil-intensivesectorsthatdeliverrelativelylower returns to investors.

Moregenerallytheimpactonthe“otherservices”sectorwillbelargelyneutral.Thesesectorswillbenefitthroughincreased demand for their products fromothersectorsoftheeconomythatare expanding as well as increased consumer spending. However, the businessesinthissectormayfindincreased competition for scarce resources,e.g.skilledlabourandinvestment,whichmaylimittheircapacitytorespondtothisincreaseddemand. A similar effect occurs in the publicsector–growthinthesectorisconstrainedbygovernmentspendingplans,andthesectorfindsitdifficult to retain skilled workers who leave for higher wages in the expanding sectors.

Although the fall in the oil price is associated with an increase in household spending, the wholesale and retailtradesectordoesnotreflectallofthe increase in spending as this sector onlycapturesthevalueassociatedwithactivitiesrelatedtothedistribution,notthe production, of manufactured goods.

Therefore, most of the value generated from increased household spending is reflectedinthemanufacturingandagriculturesectors.Theprimaryproductproducedbytheagriculturesector is food and raw material for clothing, so agriculture is therefore expected to experience a rise in demand associated with increased consumer spending.Similarlythemanufacturingsectorbenefitsbecauseitproducesconsumerdurablesandclothing.

However,whilethesesectorsmaybenefitfromlowerfuelcosts,wehavenottakenintoaccountanyadversecorresponding economic effects that might dampen economic performance inthesesectorsandreducetheirabilityto pass on lower oil prices to their customers, e.g. a weaker outlook in theEurozonemayrestricttheirability to invest.

The oil and gas extraction sector is most heavilyimpactedbythefallinoilprices(seeFigure3.7)andistheonesector

Figure 3.7: Oil and gas extraction sector - impact on level of real GVA, 2015-2020


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thatlosesoutsignificantlyintermsofGVA.Theindustryislikelytofacefurthercost pressures as highlighted in the recent ActivitySurveypublishedbyOil&GasUK, which shows the costs of operating intheUKContinentalShelfrisingby8%in2014,andproductioncostsincreasingfrom£17/barrelto£18.50/barrel.7

InScenario1,theoilandgasextractionsector suffers a severe contraction in outputandemploymentduringthefirsttwoyearsfollowingareductionintheoilprice, with higher cost producers exiting theindustryorscalingbacktheiroperations. A permanent reduction in the oilpricecouldreducethelevelofGVAinthissectorbyaround8%onaveragebetween2015and2020,withapeakoutputlossofaround12%in2016.

InScenarios2and3,wheretheoilpricereturns to a higher level, the oil and gas extraction sector could suffer a smaller contraction in output, which might moderate over time. The oil price will also have a negative effect on investment and explorationactivitybythesector.Thereissomeriskthatasignificantdownturncouldaffecttheabilityoftheindustrytoinvestinmajorinfrastructure(suchashubplatformsandpipelines),causingtheexplorationofsmallerandmoretechnicallydifficultfieldstobecomeuneconomic.

Although the fall in the oil price is permanent, it triggers an increase in demand for oil as it is now a cheaper input. The fall in the oil price also narrowsthegrowingspreadbetween oil and gas prices, which slows the rate of switchingfromoiltogas,ortorenewablesourcesofenergyinthelonger-termas

Table 3.2: Increase in total UK employment relative to baseline, 2016 vs 2020


Oil price scenario 2016 2020

Scenario 1 (staying at $50) 121,000 91,000

Scenario 2 (rising to $73 by 2020) 53,000 37,000

Scenario 3 (rising to $108 by 2020) 11,000 3,000

Table 3.3: Impact on level of employment by sector, 2020, in thousands of full time equivalents


In thousands Scenario 1 Scenario 2 Scenario 3

Construction 20.2 8.0 0.7

Wholesale and retail trade 18.9 7.8 0.7

Agriculture, forestry and fishing 13.4 5.3 0.5

Oil-intensive manufacturing 12.8 5.0 0.5

Land transport 10.9 4.5 0.4

Financial services and insurance 6.9 2.7 0.3

Non-oil intensive manufacturing 5.9 2.4 0.2

Other industry 4.4 1.8 0.2

Other service activities 2.1 0.9 0.1

Air transport 1.8 0.8 0.1


1.2 0.5 0.0


0.2 0.0 0.0

Water transport 0.0 0.0 0.0

Government -4.2 -1.8 -0.1


-2.9 -1.2 -0.1

7 Oil&GasUK“ActivitySurvey2015”

the cost saving incentives to do so are lessened. The increase in economic activityinothersectorsalsoleadstoasubsequentincreaseinthedemandforoil.Thisreboundeffectmeansthatthecontractioninoutputexperiencedby the oil and gas sector slows over time.


Impact on employment

The fall in the oil price will have a positiveimpactonemployment, which is associated with increased levels ofeconomicactivity.Theincreasedproductivityandprofitabilityamong UKbusinessesthatbenefitfromthefallin the oil price will increase demand for labourandcapital,which,inturnincreases wages and investment returns. Higher wages attract more workers into employmentinthesesectors,andunemploymentfalls.

Table3.2showstheincreaseinemploymentrelativetothebaselinefortheUKeconomyinourthreescenarios.Theemploymentimpactspeakin2016and moderate over time as the effects of loweroilpricesfilterthroughtheeconomy.Ifthereisapermanentreductionintheoilprice,theeconomywillseeanincreaseinemploymentofaround90,000by2020.Theemploymenteffects are smaller where the fall in the oilpriceistemporary:inScenarios2and3,thetotalnumberofjobsincreasesbyaround37,000and3,000respectivelyby2020.

Table3.3showstheemploymentimpactsbysectorinthousandsofjobs.The construction sector will see the largestincreaseinemploymentinabsoluteterms,followedbythewholesale and retail trade sector, andagriculture.Theoil-intensivemanufacturing sectors will also see an additional13,000jobsifthefallintheoilpriceispermanent.Inpercentagetermshowever(seeTable3.4),theagriculture, air and land transport sectors will experience the largest percentageincreasesinemployment. Asoutlinedabovethesesectorsbenefitfrom a rise in consumer spending. Both the agriculture and retail sectors

Table 3.4: Impact on level of employment by sector, 2020, in % difference from 2013


% difference from 2013 Scenario 1 Scenario 2 Scenario 3

Agriculture, forestry and fishing 2.9% 1.2% 0.1%

Air transport 2.6% 1.1% 0.1%

Land transport 2.3% 0.9% 0.1%


1.6% 0.6% 0.1%

Construction 1.6% 0.6% 0.1%

Other industry 1.5% 0.5% 0.1%

Oil-intensive manufacturing 1.4% 0.5% 0.0%


0.8% 0.3% 0.0%

Financial services and insurance 0.7% 0.3% 0.0%

Non-oil intensive manufacturing 0.5% 0.2% 0.0%

Wholesale and retail trade 0.4% 0.2% 0.0%

Other service activities 0.0% 0.1% 0.0%

Government -0.1% 0.0% 0.0%

Water transport -0.1% 0.0% 0.0%


-7.9% -3.1% -0.3%

provideanentrypointintothelabourmarketforpart-timeorlowerskilledworkers,whichmakeitrelativelyeasierfor these sectors to attract new workers and meet the predicted demand increase. The lower input costs for themanufactureofcokeandrefinedpetroleum also means that the sector willseeanincreaseinemploymentofaround1.6%wherethefallintheoilpriceispermanent.Asdescribedin theprecedingsection,thepublicsectorexperiencesafallinemploymentaspublicsectoremployeesmovetothefaster-growingprivatesectorswherewages are now higher.

The fall in the oil price will have a positive impact on employment.


Impact on inflation

The lower cost of production from the fallinoilpriceacrossarangeofenergy-intensivegoodswillbepassedontoconsumerstovaryingdegrees,andsoreduceinflationdirectlyasisalreadyapparentinthelatestCPIfigures.AlthoughtheincreaseinrealGDPandaggregate demand will exert upward pressureonprices,thisisoffsetbythecost savings that translate into lower consumerprices.Figure3.8showsthemodelled impact of negative oil price shocksonconsumerpriceinflationinour three scenarios, relative to a baselinewhereinflationremainedontargetat2%.Notethatthisignoresotherfactorsthatmayaffectinflation,soit is illustrative of how oil price changes aloneaffectinflation,ratherthanbeingforecastsofwhatwethinkinflationwillactuallybe(forwhichreadersshouldrefertoSection2above).

Figure 3.8: Impact on CPI inflation relative to baseline target level, 2015-2020


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Figure 3.9: Household expenditure, average per week, 2013

Source: ONS

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£/w

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Impact on household spending

Figure3.9showsaveragehouseholdexpenditure per week on various goods and services. Expenditure on power and fuel(includingforpersonalvehicles)accountforaround11%oftotalweeklyspend,or£50perweek.

Our modelling suggests that consumers benefitoverallfromthereductioninoilpricesasbusinessespassoncostsavingsto consumers in the form of cheaper goods and services. However, less than 1%ofelectricityintheUKisgeneratedfrom petroleum, so the fall in the oil


pricewillonlyhaveaminimalimpact onthehouseholdelectricitybills.Householdsshouldalsobenefitastheincreaseindemandforlabourinfast-expanding sectors should increase the overalllevelofwagesintheeconomy,thus increasing their spending power. Thisisoffsetslightlybythesubsequentincrease in prices due to the increase in demand for consumer goods and services,buttheoverallnetimpactis an increase in real household spending.

Figure3.10showstheimpactonhouseholdspending in real terms as a result of the fallintheoilprice.InScenario1, thepersistentlylowoilpricewillenablehouseholdconsumptiontorisebyanadditional£372ayearinrealtermsonaveragebetween2015and2020. Wherethefallintheoilpriceistemporary,the impact on real household spending issmaller,increasingby£195andjustover£100ayearonaverageinScenarios2and3respectively.

Impact on the trade deficit

Figure3.11showstheimpactonUKexportsasapercentageofGDP,asaresult of the fall in oil prices. As a net importer of crude oil and oil products, the fall in the oil price will provide a smallbenefittotheUKbynarrowing thetradedeficit.InScenario1,theexpansion in other sectors also leads to an increase in exports. However, the value of exports decreases in the short-runasthewealtheffectfromthefall in the oil price means that more goodsandservicesarebeingconsumeddomestically.ThiseffectalsoexplainswhytheimpactonUKexportsislessapparent in Scenario 1 in comparison to Scenarios 2 and 3.

Figure 3.10: Impact on real household spending average over 2015-2020

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Figure 3.11: UK exports in different oil price scenarios, 2015-2020


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Figure3.12showstheimpactonUKimports.Importsdeclineinitiallyasthecostofoilimportsfall.Inthelonger-term,althoughUKfirmsexperienceanimprovement in international competitiveness and exports increase, this also generates wealth, part of which willbespentbyhouseholdsonincreasing their consumption, including imported goods. This means that the impact on net exports is dampened as overall economic growth in the UK also drivesupimports.Onbalance,ourresultssuggestthattheUKwillenjoy asmallnarrowingofthetradedeficit as a result of the fall in the oil price.

Impact on UK government revenues

TheUKoilandgasfiscalregimeappliesto exploration for, and production of, oil in the UK and on the UK Continental Shelf.Thiscurrentlyconsistsofcorporationtax,thesupplementarycharge and the petroleum revenue tax. Figure3.13showsthetrendsingovernment tax receipts from the oil and gas sector compared to trends in oil prices.Upuntilfiscalyear2011-12, the share of government revenues from theUKoilandgassectorbroadlyfollowed trends in oil prices. However, thisrelationshipbegantodecoupleinrecentyearsassignificantdeclinesinoilproduction and increasing costs led to a reduction in tax revenues from the sector. In2012-13,taxrevenuesfellbyaround45%to£6.1billion,andthenfellagaininthefollowingyearbyaround25%to £4.7billionduetolowerproductionlevels and higher expenditure. These trends are linked to the increasing maturityoftheNorthSeafieldsasoil andgasfrommarginalsitesbecomemoreexpensiveanddifficulttoextract.

Figure 3.13: Revenues from the UK oil and gas sector

Source: ONS, Thomson Reuters

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Figure 3.12: UK imports in different oil price scenarios, 2015-2020


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Figure 3.14: Net impact on government tax revenues per annum, average over 2015-20


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Ouranalysissuggeststhatthereductionin oil price will have a small positive impact on overall government tax revenues(seeFigure3.14).Althoughtaxrevenues from the oil and gas sector are likelytodecline,risingtaxcontributionsfromothersectorsoftheeconomywillmorethanoffsetthislossastheyexpand.InScenario1,theUKgovernmentreceives£6.7billiononaverage in additional tax revenues between2015and2020,whichisaround1.4%oftotaltaxrevenues. The additional tax impacts from a temporaryfallintheoilpricearesmaller–ataround£3.2billionand£1.3billioninScenarios2and3respectively.

Inourmodelweassumethattheoverallincrease in government tax receipts is transferredbacktoconsumersvialump-sumtransfers,whichprovide afurtherboosttoconsumerspendingand economic output.

3.4 – Summary and conclusionsThe fall in the oil price should have asignificantpositiveimpactontheUKeconomybyincreasingoveralleconomicactivityasthecostofproductiondecreasesforbusinesses,especiallyforthose that are dependent on oil inputs. Although the oil and gas extraction sectorisnegativelyaffectedbythereduction in the oil price, sectors such as agriculture, air transport, coke and refinedpetroleummanufacturingandoil-intensivemanufacturingsectorswillbenefitasthepriceofakeyinputfalls.

Water transport and other services sectorswillenjoyasmallpositiveimpact.However,oil-intensivesectorsarelikelytobenefitfromthereallocation of capital and resources at theexpenseoflessoil-intensivesectors.

Futureoilpricetrendsremainhighlyuncertain, so we have looked at three alternativescenarios.Inacasewherethe reduction in the oil price is persistent,thesizeoftheUKeconomyincreasesbyaround1%onaveragerelativetothebaselinebetween2015and2020.Employmentalsoincreases byaround90,000by2020.

Incontrast,theimpactsaremuchsmaller where the fall in the oil price iswhollyorpartiallytemporary: in these scenarios the average impact onthelevelofGDPis0.2-0.5%, withemploymenteffectsin2020ofbetween3,000and37,000dependingonhowfarandfastoilpricesrebound.

Real household incomes also rise, which increases consumer spending. Asaresultofgrowingeconomicactivity,government tax revenues increase as the tax take from corporate and personal incometaxesincreasebymorethanthelossofNorthSeaoilandgasrevenues.

Insummary,loweroilpricesshould bepositiveformostsectorsofthe UKeconomy,householdsandthegovernment. But the scale of these benefitsremainshighlyuncertaindepending on how oil prices evolve from here.


Technical Appendix: Modellingoilpricechanges

Table3.5setsouttheoilpriceprojectionsforeachscenarioinouranalysis.

As part of our modelling exercise, we also undertook a literature review of studies on the impact of an oil price shock on oil importing countries. Cournede(2010)foundthatanincreaseintherealoilpriceof65%reducesUSpotentialoutputby1.3%,implyinganelasticityofoutputtotheoilpriceofaround-0.02.TheauthorfoundsimilarestimatesfortheEUwherea59%increase in the real oil price reduces EU potentialoutputby0.7%,whichimpliesanelasticityofaround-0.01.AmorerecentstudybytheBankofEngland(2013)showsthatanincreaseinoilpriceofaround10%leadstoareductioninoutputofaround0.2%inUK.

Theseestimatesvarywidely,dependingontheoilintensityoftheeconomy,dependenceonenergyimportsandmethodology.Wecomparedtheestimates of elasticities from the academicliteraturewithouranalysis,and found that our results were in line with most other estimates. These are summarisedinTable3.6.

8 Millard,S.andShakir,T.(2013)“OilshocksandtheUKeconomy:thechangingnatureofshocksandimpactovertime”,BankofEnglandWorkingPaperNo.476,August2013.

9 Peersman,G.andVanRobays,I.(2012)“Cross-countrydifferencesintheeffectsofoilshocks”,EnergyEconomics,Volume34,Issue5,September2012,Pages1532-154710 Cournede,B.(2010)“Gaugingtheimpactofhighercapitalandoilcostsonpotentialoutput”,OECDEconomicsDepartmentWorkingPapersNo.789,July2010.11 Duval,R.andVogel,L.(2008)“Oilpriceshocks,rigiditiesandtheconductofmonetarypolicy”,OECDEconomicsDepartmentWorkingPapersNo.603,April2008.12 Barrell,R.andKirby,S.(2008)“Thebudgetaryimplicationsofglobalshockstocyclesandtrendsinoutput:impactsofhousing,financialandoilshocks”,October2008.13 Blanchard,O.andGali,J.“Themacroeconomiceffectsofoilpriceshocks:whyarethe2000ssodifferentfromthe1970s?”,NBERworkingpapersNo.13368,2007.

Table 3.5: Oil price scenarios, US$/barrel

Scenario 2015 2016 2017 2018 2019 2020

Baseline 108 108 108 108 108 108

Scenario 1 50 50 50 50 50 50

Scenario 2 57 64 68 71 72 73

Scenario 3 60 68 76 85 96 108

Note: Oil prices calculated as an average of Brent crude, WTI and Dubai.

Table 3.6: Estimates from academic literature compared to PwC estimates

Reference Impact of a 1% increase in oil prices on GDP, %

Time period

PwC study Scenario 1: -0.024%

Scenario 2: -0.015%

Scenario 3: -0.010%

5 years (projected)

Bank of England (2013)8 UK: -0.02 36 years (1975-2011)

Peersman and Van Robays (2012)9 US: -0.04

Euro area: -0.04

22 years (1986-2008)

Cournede (2010)10 US: -0.02%

EU: -0.01%

3 years (2007-2009)

Duval and Vogel (2008)11 OECD: -0.03% 10 years (projected)

Barrell and Kirby (2008)12 UK: -0.04% 2 years (2008-2009)

Blanchard and Gali (2007)13 UK (1970-1983): -0.1%

UK (1984-2007): -0.02%

37 years (1970-2007)

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