Since our December forecast, sterling oil prices have fallen significantly. We now expect the sterling oil price to average £36 a barrel in the first quarter of this year – around 30 per cent lower than the level implied by our December forecast. By the end of the forecast period, sterling oil prices are 17 per cent lower in this forecast than was the case in December. There are a number of channels by which this decline is likely to affect prospects for GDP growth in the UK:

  • the fall in consumer prices will increase households’ real income, which is likely to feed through to higher real consumption;
  • lower energy-related production costs and stronger domestic demand may support business investment and capital accumulation;
  • UK trade tends to be more heavily weighted to oil importers than to oil exporters, so a boost to real consumption in those economies may support demand for UK exports; and
  • lower oil prices make the North Sea less profitable, which is likely to reduce production, exports and investment by oil and gas extraction companies.

As a net oil importer, a fall in the oil price would be expected to have a positive net effect on UK GDP. A number of factors will affect the size of this boost. For example, a temporary oil price change would be expected to have a smaller effect than a permanent change because its effects would also be expected to be temporary. The response of the economy will also depend on the extent to which the oil price change reflects the influence of supply or demand: if lower oil prices primarily reflect weaker world demand, then an associated reduction in UK export growth may partially offset any improvement in real incomes. Disentangling the role of supply and demand in the recent decline in the oil price is difficult, although most analysis points to a role for both factors. See Box 2.1 for further discussion.

Empirical studies point to a wide range of possible effects of oil price changes on UK GDP:

  • using data since 1984, Blanchard and Gali (2007)a find that an increase in oil prices of 10 per cent reduces UK output by around 0.5 per cent;
  • simulations produced by the National Institute for Economic and Social Research (NIESR) suggest that a permanent reduction in the oil price of $20 a barrel – a reduction of around 20 per cent relative to NIESR’s baseline – could lead to a permanent increase in the level of UK GDP of around 0.5 per cent.b A temporary shock would have a much more modest effect, increasing GDP growth by 0.1 percentage points in the near term, but reducing GDP growth after two years as interest rates are assumed to rise in response to the increase in the oil price to previous levels;
  • recent simulations by the Bank of Englandc using COMPASS (the Bank’s central forecasting model), indicate that a 10 per cent fall in oil prices could raise the level of GDP by around 0.1 per cent after two years, with the increase in demand mainly resulting from higher real wages;
  • Millard and Shakir (2013)d find that the effect of an oil price shock on UK GDP depends both on the source of the shock and the time period over which the effect is estimated. Based on the period from 1976 to 2011, a 10 per cent increase in the oil price that is entirely driven by weaker supply would be expected to reduce GDP by 0.12 per cent, while a world-demand driven increase in the oil price of the same magnitude would be expected to increase UK GDP by around 0.03 per cent. The size of the GDP effect is even smaller when estimated over a more recent sample period; and
  • in 2010, the interim OBR set out an assessment of the effect of oil price fluctuations on the economy and public finances.e A permanent 20 per cent increase in the real oil price was assumed to reduce GDP by around ½ per cent, although this estimate did not incorporate any offsetting effect on North Sea output, and was based on the assumption that any effect of oil prices on potential output would occur relatively quickly. We expect the fall in the oil price to provide a small boost to productivity growth of around ¼ per cent. This is smaller than was assumed in the interim OBR study, and reflects an assumption that any effect on potential output from stronger capital accumulation will build relatively slowly. For this forecast we have also incorporated the effect of lower oil prices on North Sea production, which is expected to reduce GDP by 0.3 per cent by the end of the forecast period, part of which we expect to be offset by measures announced in the Budget (see Box 3.2).