The impact of declining oil prices

Will falling oil prices have an impact on the UK construction market and economy as a whole?

Introduction

In recent months we have seen a dramatic fall in the price of oil. For many consumers this is a welcome boost with regards to reduction in transport costs and other business costs resulting in a reduced cost of living and a lower inflation rate. In layman’s terms, a fall in oil prices is effectively like a free tax cut giving the consumer an extra discretionary income to be spent on other goods. 

Macroeconomic effect 

The general effect of low oil prices affects the construction sector in a number of ways:

Lower inflation leading to lower interest rates: Just as the oil shocks of the past heralded a surge in interest rates, so oil prices reduces the need for higher rates. 

Higher construction GDP output: the construction sector could gain significantly from a reduction in the oil price. As business investment rises following the increase in intermediate demand and consumer spending, businesses needing to expand will move to new premises, enlarge existing premises or engage in refurbishment. The construction sector will be the primary provider of these services.

Higher employment: The fall in oil prices will have a positive impact on construction employment and with it increased levels of economic activity. The increased productivity and profitability among UK construction companies that benefit from the fall in the oil price will increase demand for labour and capital, which, in turn increases wages and investment returns. Higher wages attract more workers into employment in these sectors, and unemployment falls. The findings of a recent BCIS report showed the UK experiencing a shortage of skilled labour which has driven up tender prices by 10% in 2015 a trend which is continuing to rise.

Increased balance of payments: As the UK is one of the leading net importers of oil, lower oil prices boost real income, including large economies such as China and India which will support global activity. But there would be some offset at the global level from a decrease in the incomes of oil exporters.

Possible impact to the UK construction sector and overall economy

Deflationary fears

The fall in oil prices is mainly due to a weak global demand, especially from China. This has effected other commodities for example with the price of steel being badly hit. This reduction in demand is compounded by Saudi Arabia and the OPECs continuous oversupply of oil to the market. Their efforts to drive off competition from the fracking and shale producers, who would normally invest in fossil fuel extraction in turbulent times appears to be backfiring amid political instability in the middle east. This policy has been very counterproductive. The recent collapse in the currencies of oil exporters such as Russia has affected the markets across the globe and these issues do not help global recovery.

The biggest concern from Europe and the UK political environment is the fear of moving towards deflation. The current UK inflation at 0.2% nearing zero and effects of deflation like that experienced recently by Japan, tends to have serious macro-economic problems such as:

Low consumer spending and investment: deflation effects consumer confidence which results in consumers and firms delaying spending and investment. Deflation will have a huge impact on investment in the construction sector, especially from foreign hedge funds investing in the property market. Deflation discourages consumer spending because consumers expect prices to be cheaper in the future.

Debt to GDP burden: Deflation will make it harder for UK and Eurozone countries with high Debt to GDP ratios to reduce their burden. The accumulated debt burden in the UK is at 80% of GDP, the highest peacetime level this century. The current conservative government has expressed concerns about the consequences of deflation and continues to commit to more debt, because deflation would make paying off the loan even more expensive.

The fear of deflation is brought about by the difficulty of trying to recover once it takes hold, which results in prolonged stagnant growth. According to the Financial Times, energy costs make up more than a tenth of Eurozone consumer price inflation, which is why falling oil prices could easily lead to deflation. Japan experienced this for over a decade and suffered dearly.

Environmental fears

Cheap oil encourages waste and deters investment in more efficient renewable energy sources. Cheap oil leads to high oil consumption and an increase in local pollution and CO² emissions due to drivers feeling less pressed to trade in their gas guzzling SUVs for a G-Wiz car. The oil glut shows no signs of easing, as major producers such as Saudi Arabia and other OPEC nations are reluctant to reduce output.

Cheap oil has a negative impact on investment in low carbon energy sources. However, data from Bloomberg New Energy Finances states that the UK clean energy sector remained resilient despite the continued Eurozone decline, with record investment levels of over $15bn in 2015, an increase of 24% on 2014.

"energy costs make up more than a tenth of Eurozone consumer price inflation, which is why falling oil prices could easily lead to deflation"

Methods to combat the adverse market forces 

The UK government must take action to reduce its national debt and take measures to control downward inflation. Through decisive fiscal and monetary policies, the government and the Bank of England should tackle the issue by:

The government targeting positive inflation: measures such as quantitative easing may work. By increasing the money supply, the Bank reserves should rise and encourage them to lend more.

The Bank of England increasing interest rates: this may ease the pressure on the housing market from overheating.

The government introducing an increase in VAT on imported goods such as cars, electronic goods, and/or introduce a carbon pricing mechanism or any other regulatory mechanism, i.e. tax on CO² emissions.

The UK government impose further tariffs on imports such as raw steel from countries outside the EU.

The measures in item (c) are best introduced when prices are very low, and its impact would have a negative outcome.

Conclusion 

The impact of low oil prices has not adversely affected the construction industry as a whole, but has contributed in a small way in curtailing the current upward trend in the tender price index.