Sitting in India and looking and feeling at the impact of low crude prices cushioning the trade deficit and keeping the CAD (current Account Deficit) in check has given me a lot of relief beside giving newly elected Government and PM some confidence on trying to start major reforms (though nothing seems to be happening on the ground) but the plummeting price of oil is still the biggest energy story in the world. It’s bringing back cheap gasoline to the United States while wreaking havoc on oil-producing countries like Russia and Venezuela.
But why does the price of oil keep falling unabated? Back in June 2014, the price of Brent crude was up around $115 per barrel. As of January 23, 2015, it had fallen by more than half, down to USD 49 per barrel.
For much of the past decade, oil prices have been high — moving around $100 per barrel since 2010 — because of soaring oil consumption in countries like China and conflicts in key oil nations like Iraq. Oil production in conventional fields couldn’t keep up with demand, so prices spiked.
BY 2014, OIL SUPPLY WAS MUCH HIGHER THAN DEMAND
But beneath the surface, many of those dynamics were rapidly shifting. High prices spurred companies in the US and Canada to start drilling for new, hard-to-extract crude in North Dakota’s shale formations and Alberta’s oil sands. Then, over the last year, demand for oil in places like Europe, Asia, and the US began tapering off, thanks to weakening economies and new efficiency measures.
By late 2014, world oil supply was on track to rise much higher than actual demand. A lot of unused oil was simply being stockpiled away for later. So, in September, prices started falling sharply.
As prices slid, many observers waited to see whether OPEC, the world’s largest oil cartel, would cut back on production to push prices back up. (Many OPEC states, like Saudi Arabia and Iran, need higher prices to balance their budgets.) But at its big meeting last November OPEC did nothing. Saudi Arabia didn’t want to give up market share and refused to cut production — in the hopes that lower prices would help throttle the US shale boom. That was a surprise. So oil went into free-fall.
The oil price crash is now upending the global economy, with ramifications for every country in the world. Low prices are excellent news for oil consumers in places like Japan or the US, where gasoline is the cheapest it’s been in years. But it’s a different story for nations reliant on oil sales. Russia’s economy is facing a potential meltdown… Venezuela is facing unrest and may default on its debt. Even better-prepared countries like Saudi Arabia could face heavy pressure if oil prices stay low.
Why oil prices plummeted in 2014
Let’s go back to the mid-2000s. Oil prices were rising sharply because global demand was surging — especially in China — and there simply wasn’t enough oil production to keep up. That led to large price spikes, and oil hovered around $100 per barrel between 2011 and 2014.
Yet as oil prices increased, many energy companies found it profitable to begin extracting oil from difficult-to-drill places. In the United States, companies began using techniques like fracking and horizontal drilling to extract oil from shale formations in North Dakota and Texas. In Canada, companies were heating Alberta’s gooey oil sands with steam to extract usable crude.
This led to a boom in “unconventional” oil production. The US alone has added 4 million extra barrels of crude oil per day to the global market since 2008. (Global crude production is about 75 million barrels per day, so this is significant.)
Up until very recently, however, that US oil boom had surprisingly little effect on global prices. That’s because, at the exact same time, geopolitical conflicts were flaring up in key oil regions. There was a civil war in Libya. Iraq was facing threats from ISIS. The US and EU slapped oil sanctions on Iran and pinched its oil exports. Those conflicts took more than 3 million barrels per day off the market.
By mid-2014, however, those outages and conflicts were no longer quite as important. Production in the United States and Canada was still rising fast — and the world’s supply of oil kept growing.
Even more significantly, oil demand in Asia and Europe suddenly began weakening- thanks to slowdowns in China and Germany. More broadly, oil demand has been flat lining in lots of places around the world. The United States, once the world’s biggest oil consumer, has seen gasoline consumption stagnate as cars became more fuel efficient. At the same time, countries like Indonesia and Iran have been cutting back on subsidies for fuel users.
That combination of weaker-than-expected demand and steadily rising supply caused oil prices to start dropping from their June peak of $115 per barrel down to around $80 per barrel by mid-November. And that was only the start…
OPEC’s surprising response: Let prices keep falling
That brings us to OPEC, a collection of oil-producing nations that pumps out about 40 per cent of the world’s oil. In the past, this cartel has sometimes tried to influence the price of oil by coordinating either to cut back or boost production.
At its big meeting in Vienna on November 27, there was a lot of heated debate among OPEC members about how best to respond to the drop in oil prices. Some countries, like Venezuela and Iran, wanted the cartel (mainly Saudi Arabia) to cut back on production in order to prop up the price. These countries need high prices in order to “break even” on their budgets and pay for all the government spending they’ve racked up:
On the other side of the debate was Saudi Arabia, the world’s second-largest crude oil producer, which was opposed to cutting production and seemed willing to let prices keep dropping.
Why was that? For one, officials in Saudi Arabia remember what happened in the 1980s, when prices fell and the country tried to cut back on production to prop them up. The result was that prices kept declining anyway and Saudi Arabia simply lost market share. What’s more, the Saudis have signalled that they can live with lower prices in the short term. (The government has built up $750 billion in foreign-exchange reserves to finance deficits.)
SAUDI ARABIA WAS IN FAVOR OF LETTING PRICES CONTINUE TO FALL
In the end, OPEC couldn’t quite agree on a response and ended up keeping production unchanged. “We will produce 30 million barrels a day for the next 6 months, and we will watch to see how the market behaves,” said OPEC Secretary-General Abdalla El-Badri after the meeting.
That caused the price of oil to start crashing even further. The price of Brent crude went from $80 per barrel to $70 per barrel in just a few days. And it kept tumbling to down below $60 per barrel by mid-December and $50 by January.
For all intents and purposes, OPEC is now engaged in a “price war” with the US. What that means is that it’s relatively cheap to pump oil out of places like Saudi Arabia and Kuwait. But it’s more expensive to extract oil from shale formations in places like Texas and North Dakota. So as the price of oil keeps falling, some US producers may become unprofitable and go out of business. And the price of oil will stabilize. At least that’s what OPEC members hope.
A big question: Will the strategy to keep low oil prices kill the US shale boom?
By January 2015, it was clear that low prices were starting to pinch producers in the United States and Canada. The only real question is how much it would hurt.
US shale projects are especially vulnerable when oil dips below $60 per barrel. Fracking wells tend to deplete quickly — with output falling about 65 per cent after the first year — so new wells have to be drilled constantly. So, when the price falls, many companies can respond quickly by scaling back on new drilling. Already, firms are pulling out of places like Texas’ Permian Basin, and the number of US rigs has fallen 15 per cent from December to January.
But not everyone is leaving all at once: Some companies have sunk costs and need to keep drilling. Others may try to cut their costs and grit it out. It really varies from company to company. What’s more, the situation is different up in Canada: oil sands projects have huge upfront costs, but once those are paid off, they can keep producing oil cheaply for many decades.
The US Energy Information Administration still expects that overall US oil production will grow another 700,000 barrels per day in 2015 — though that’s slightly lower than the prediction when prices were high. We’re about to see if that’s right.
How falling oil prices could affect Russia, Venezueal, Nigeria, Iran, the US and India
The plunge in oil prices is having significant economic consequences around the world. A few examples:
Russia: Russia’s situation is getting the most attention these days. The country’s is hugely dependent on oil and gas production — with oil revenues making up 45 per cent of the government budget — and the sharp fall on prices has been ruinous.
RUSSIA’S ECONOMY IS EXPECTED TO SHRINK 4.5% NEXT YEAR IF OIL STAYS AT $60 PER BARREL
Economists now estimate that Russia’s GDP will shrink at least 4.5 per cent in 2015 if oil says below $60 per barrel. The plunging price of oil has also caused the rouble’s value to collapse — which is leading to panic inside Russia and a rise in inflation, as imports become drastically more expensive. Many Russians, worried that their savings may vanish, have been rushing out to buy cars and washing machines — anything that has more lasting value than currency.
So far, Russia’s central bank has been struggling to deal with this crisis. On December 15, 2014, the country suddenly hiked interest rates from 10.5% to 17% in an attempt to stop people from selling off roubles. But those rate hikes are likely to slow the country’s economy down even further.
Iran: Iran’s economy had recently started to rebound after years of recession. The International Monetary Fund had been projecting that the country was on track to grow 2.3 per cent next year. But that was all before oil prices started to plunge — a potentially precarious situation for the country.
One big problem for Iran is that it also needs oil prices well north of $100 per barrel to balance its budget, especially since Western sanctions have made it much harder to export crude. If oil prices keep falling, the Iranian government may need to make up revenues elsewhere — say, by paring back domestic fuel subsidies (always an unpopular move, at least in the short term).
Venezuela: Venezuela entered the period of low oil prices with an already frail economy ruined by the more than a decade-long socialist regime of Hugo Chavez and his successor Nicolas Maduro. The oil price slump significantly worsened the country’s already failing economy.
More than 90 per cent of Venezuela’s exports and hard currency reserves depend on oil, and with the price of oil 50 per cent down, the country is close to a default.
Standard & Poor’s is the last in a line of rating agencies that downgraded Venezuela’s credit rating to junk status and the country’s currency is experiencing a constant devaluation trend. At the same time, inflation is expected to rise to 200 per cent this year and the economy to shrink by 7 per cent.
Consequently, the Maduro government is forced to cut subsidies introduced by the Chavez regime, and to liberalize the economy in accordance with the global realities in the oil markets, which could not only cause strong economic shocks and public outcry, but also trigger a swift regime change.
Nigeria: Africa’s largest economy is under increased pressure after the sudden drop in oil prices in the last eight months. This is the second blow for one of the continent’s largest oil exporter’s after the shale boom virtually brought to a halt its oil exports to the United States.
The country’s budget breakeven price of oil for 2015 is $122, according to Deutsche Bank estimates. Moreover, oil exports constitute more than 70 per cent of Nigeria’s budget income and 90 per cent of its foreign exchange.
As a result, the Nigerian naira has lost a fifth of its value against the US dollar since June 2014. In addition, security instability caused by the Boko Haram campaign in the predominantly Muslim-populated north of the country and the political turmoil ahead of the presidential elections expose bitter divisions along the ethnic and regional lines that could further destabilize the country.
Saudi Arabia: There’s no question that Saudi Arabia, the world’s second-largest crude producer (after Russia), will suffer financially from cheap oil. If oil stays at around $60 per barrel next year, the government will run a deficit equal to 24 per cent of the GDP.
For now, however, the Saudis are toughing this out — and show no sign of trying to prop up prices as they have in the past. The kingdom has built up a stockpile of foreign currency worth some US$ 750 billion, which it will use to finance its deficits. In December, the country’s oil minister, Ali al-Naimi, said he didn’t care if prices crashed to $20 or $40 per barrel; he wasn’t going to budge from his position. “It is not in the interest of OPEC producers to cut their production, whatever the price is,” he said.
The United States: In the US, meanwhile, a fall in crude prices will have both positive and negative impacts. For many people, it will offer an excellent economic boost: cheaper oil means lower gasoline prices — which have fallen to US$ 2.04 per gallon, the lowest since 2009:
The EIA projects that US drivers will spend about $550 less on gasoline in 2015 than they did in 2014, assuming prices stay low. That will give consumers more money to spend on other things.
But it’s not all good news. Oil-producing states like Texas and North Dakota are likely to see a drop in revenues and economic activity. The falling price of oil is also putting severe pressure on Alaska’s state budget. All told, oil prices are likely to be good for 42 states and bad for the other 8.
If the price drop lasts a long time, that could also spur people to start using more oil. Case in point: In recent years, high gasoline prices have spurred many Americans to buy smaller, more efficient cars. But if gasoline prices fall, bigger cars and SUVs could make a comeback. (That said overall US fuel economy will still keep rising over time — because the federal government has imposed new standards on cars and light trucks through 2025. But this might now happen more slowly.)
India: Oil is critical for India. For one, India imports more than two- thirds of its requirement, which constitutes 37 per cent of total imports. A one-dollar fall in the price of oil saves the country about 40 billion rupees.
That has a three-fold effect spread across the economy.
First, if the average fall in oil prices is about $4 per barrel in 2014-15, the trade deficit will shrink by about $3 billion. In the April-June quarter, the current account deficit had dropped to $7.5 billion, mainly due to customs duty on gold imports. Add to that the fall in oil prices and the current account deficit should come down further and harden the rupee against the dollar.
Second, the fall in international oil prices will reduce subsidies that help sustain the domestic prices of oil products. Petrol prices are already decontrolled. The more commonly used diesel has been subject to staggered deregulation since September 2012.
In September this year, the difference between domestic and international prices of diesel will be only 8 paisa per litre, which can make diesel eligible for deregulation in about a month.
It is kerosene and liquefied petroleum gas (LPG) that are still heavily subsidized. And looking at the mood of the government, they are unlikely to be market-priced in the near future. The total subsidy on petroleum products in 2013-14 was 854 billion rupees and it will be reduced to the extent the international price of crude declines. The advantage will accrue mainly to the government and oil-producing companies such as ONGC and OIL. Consequently, the fiscal deficit that in 2014-15 is projected at 4.1 per cent of GDP may be somewhat reduced.
Third, the fall in international prices of oil will have a soothing effect on inflation. But it won’t be strong enough because the consumption of oil in industry is not that high except in the manufacture of certain products like carbon black.
Can we expect global oil prices stay low?
The drop in oil prices and demand reflects heightened energy production in North America, better technologies and the declining market power of the OPEC countries.
This is very hard to predict. The cost of extraction from shale finds is very expensive and thus the prices may see an upward trend sooner as the demand for OIL is expected to pick up in US around December but with recession in Canada, looking at the slowdown in the Chinese manufacturing industry and other parts of the world and If oil demand remains weak and production stays high, prices might not bounce back for some time.
In January, both Iraq and Russia had announced that they were exporting more oil than ever, and prices slumped even further.
If history is any indication, oil prices will eventually rise again, though it could take some time. And some experts think we should be preparing for that day. In the Financial Times, energy expert Michael Levi wrote a piece on how the US (and other countries) could take advantage of low oil prices to make needed energy-policy reforms — such as ending wasteful fossil-fuel subsidies or putting in place new efficiency measures. That would help countries insulate against future price shocks.
Seven factors driving a long-term oil price decline:
North American shale oil production: The shale oil and gas revolution in the United States has led to an increase of more than 4 million barrels per day in domestic oil production since 2008. Combined with an almost million-barrel-per-day increase from Canada’s Alberta tar sands, the surge has significantly reduced American demand for imported oil.
Declining role of OPEC: Most members of the Organization of the Petroleum Exporting Countries face massive fiscal shortfalls because of low oil prices. To avoid further domestic unrest, these 12 nations are unlikely to reduce oil output, which would lead to even larger fiscal shortfalls. This makes unlikely coordinating reductions in oil production among the OPEC countries aimed at raising the global price.
Standardization of oil well drilling: The share of global oil production from the OPEC countries should continue to fall as more countries make use of shale oil and gas production technology developed in the United States.
Cost difference between natural gas and oil: A key driver of a reduced global demand for oil is the development of technologies that are able to exploit the differential between the dollars per unit of energy price of oil versus natural gas. Even at $40 per barrel, the dollar per MMBTU (stands for one million British thermal units) price of oil is much higher than the dollar per MMBTU price of natural gas.
Technology innovations: A new innovation – CNG-in-a-Box technology – captures the natural gas that was formerly being flared off at the oil well and produces compressed natural gas (CNG) for use in vehicles and in drilling equipment, reducing the demand for diesel fuel. This technology makes productive use of natural gas in regions without natural gas pipeline infrastructure.
Shale oil and gas technology exports: Though the recent reductions in oil and natural gas prices have caused investments in oil and natural gas exploration and drilling in the United States to decline, exported natural gas prices in the remainder of the world, particularly Latin America and Asia, remain much higher. This fact and a robust global oil demand driven by China and the developing world will continue to support continued investments in oil and natural gas exploration outside the United States.
Oil supply curve flattening: The technology of shale oil and natural gas extraction involves much higher costs associated with the production of each barrel of oil because of the rapid rate of depletion of the resource for each shale oil or gas production rig. Conventional natural gas and oil wells have significantly slower rates of decline. This logic implies that in order to sustain production from a shale oil or gas resource, the continual drilling of new wells is necessary. As a result, it is possible to scale up and scale back shale oil and gas production more rapidly in response to demand surges, which should lessen oil and natural gas price volatility.
*Basant Tomar is a sales and business development expert with over 12 years of experience in Indian and international markets.
OIL and Global Economy – The story So Far