One of the more favourable economic "surprises" over the past six months has been the fall in oil prices. Already the gain is clear to anyone who has filled their car in recent days. However, there are significant additional benefits for European economies from lower oil prices, though these will take longer to come through.

In the short term, people tend to stick to their driving habits even when the price of petrol has fallen. So demand in the short run is insensitive to price changes. The supply of oil also reacts slowly to price. However, the supply of oil does, eventually, alter in response to price changes.

Higher prices encourage exploration and investment, and it becomes economic to operate more expensive wells. High oil prices over the last five years did result in new sources brought into production.

Two very large oil price shocks, the first in late 1973 and the second in 1979, arose following conflict in the Middle East. Supply fell, demand was slower to fall, and prices rose sharply.

However, what markets did not factor in was that, at the new high price, it became very profitable to look for more oil. In addition, many entrepreneurs realised there was big money to be made in enhancing energy efficiency. The result was massive investment in oil exploration and big expenditure on research on energy-saving technologies.

But it was about 12 years after the first oil price shock that this investment began to impact, with more abundant oil, and falling demand for petrol as cars became more fuel-efficient. These factors resulted in a collapse in oil prices in 1985. People continued to use more energy-efficient cars and other technologies, although energy was now cheaper – thus the price surge in the 1970s had a permanent effect in reducing energy demand worldwide.

This suggests price signals are pretty important, not just to reduce demand, but also to make research in energy efficiency (and carbon saving) an attractive proposition for the business community.

In the 2000s, the growth in the world economy, especially in China, led to a major increase in demand for oil. As a result, up to 2008 there was a very big rise in prices. Then the advent of the economic crisis in 2008 reduced the demand for oil and, hence, the price. With some recovery in the world economy, and especially with continued growth in China, prices in the last few years returned to a high level.

However, over the last six months we have seen a dramatic turnaround, with oil prices collapsing. In some ways it is a repeat of what happened in 1985 – the delayed consequence of an earlier price shock.

Exploration encouraged

The recent price collapse is primarily due to an increase in supply. Just as in the early 1980s, the high prices of recent years encouraged exploration and development of new sources of oil – from shale rock in the US and tar sands in Canada.

These sources are expensive but, once discovered at a high cost, much of the increased supply from these sources will continue, although they are particularly nasty from the point of view of global warming. Further exploration of these sources of oil is being drastically cut. As a result, the current low price of oil will probably not persist indefinitely.

Nonetheless, the fall in oil prices is a very significant benefit for the European economy, just when it could do with a boost. In a report published a week ago, the Euroframe consortium of economic research institutes (including the Economic and Social Research Institute) presented one of the first analyses of the possible impact of the recent fall in oil prices on the euro zone this year and next year. This report suggests that, if the fall in prices persists for a number of years, growth in 2015 could be 0.7 of a percentage point higher than it would have been without the fall in the price of oil, and an additional 0.4 could be added to the growth rate of gross domestic product next year. This is certainly good news.

Immediate impact

The most immediate impact of the fall in oil prices is to increase real incomes of everyone in Europe. However, the lower oil prices have also exacerbated the potential danger that Europe could experience deflation, which would inhibit economic activity by encouraging people to postpone spending, and it would also increase the real burden of debt.

The European Central Bank’s quantitative easing is intended to raise inflation towards its mandated target of 2 per cent. This injection of funds by the ECB will add to economic growth. This informs the Euroframe forecast of growth in GDP of over 1.5 per cent this year in the euro zone, considerably more optimistic than the International Monetary Fund’s 1.2 per cent.

The major downside to the fall in oil prices is the possible long-term effect on the environment. In the late 1970s and early 1980s, high oil prices drove research into energy efficiency. In more recent years, high oil prices encouraged research and development into both energy efficiency and clean technologies. Low prices could slow the search for clean and fuel-efficient technologies.

There is a case for governments to raise carbon taxes to promote energy efficiency and continued research, and to recycle the additional revenue into reducing other taxes. That way, both the public and the planet would gain. euroframe.org