Oil prices are plummeting across the world with both the American WTI and Brittan’s Brent Crude falling sharply in Q4 2014. We look to understand why oil prices are falling and what will be the impact to the world economy if crude oil prices sustain a substantially lower average price in 2015 than what they have done in the prior 4 or 5 years.
Supply and demand factors strongly influence oil markets, just like any other. The sharp tumble in the price of crude in Q4 2014 reflects an increase in the supply of oil, especially as a result of the North American shale boom, and an easing of demand. Changes in demand reflect more efficient energy use, sluggish global economic growth and a switch to alternative energy sources.
Given that both supply and demand factors are moving in directions that ease prices, this suggests that in the short term we should expect continued downward price pressures. Once however, substantial growth returns to the global economy, prices can be expected to rise.
Supply-side changes to the market
In recent years there have been a number of significant changes to supply-side factors. The most significant has been the shale oil boom, most prominent in the US, but gathering momentum elsewhere. It has increased US production to more than 8.5 million barrels per day (bpd). To put this into perspective the last time that the US produced this much oil on a monthly basis was 1986.
The sharp increase in production is a relatively new phenomenon. In 2011, the US averaged production of around 5.5 million bpd and now with production approaching 9 million bpd it is the on track to become the biggest oil producing nation, expected to out produce even Saudi Arabia by the end of 2016. This additional increase of more than 3 million bpd has pushed the US towards energy independence with imports of oil now below locally produced oil. This has prompted predictions that with US oil production growing at between ½ a million and 1 million barrels per day that within just ten, or at the most 20 years, the US will no longer need to import oil or gas.
The second major factor on the supply side is renewed production from Iraq and Libya, which has been restored as regional conflict has eased. The final major supply side factor is the reluctance of Organization of the Petroleum Exporting Countries (OPEC) and other major producers to reduce the quantity of oil that they are supplying. In November 2014, OPEC had the opportunity to reduce its collective output (which accounts for 40 per cent of global oil), but chose to maintain its production quantities. Whether OPEC’s decision was political with countries like Saudi Arabia attempting to gain market share at the expense of their higher cost competitors, or the real needs of countries like Nigeria, Venezuela and non OPEC Russia, to maintain production quantities to ensure their government spending programmes can be met, volumes didn’t fall.
Changes in the Demand for Oil
The decline in oil prices largely reflects supply-side issues, but at the same time, demand has remained stagnant. Across the global economy, and particularly in Europe and Japan, demand for oil has slowed. The recent return to economic growth that the US and UK have enjoyed has not been reflected elsewhere. With limited economic growth, alternative energy sources coming online, and more efficient vehicles being manufactured, the global demand for oil hasn’t increased sufficiently to absorb the supply increase. In light of this, OPEC’s decision to continue to pump amid falling prices has meant that, for the time being, oil will be faced with further downward price pressures.
The Winners and Losers
The immediate impact of reduced prices should be viewed along the lines of winners and losers rather than producers and consumers because the two groups aren’t perfectly correlated. In fact, some producers are winners and others are losers at lower price points.
The big winner from the lower oil price is the general oil consumer. Large oil-consuming nations like China, and of course the US, are big winners with China using the lower price to increase its national stock of oil reserves, and the US seeing lower prices boosting consumer spending and economic growth. The US however, poses a complex situation. On the one hand, it is enjoying the obvious positives of lower-priced oil, but on the other hand, the shale boom has created investment and jobs, more than 100,000 in fact. As oil prices fall future investment and jobs could be put at risk as we saw in December 2014 as oil majors delayed capex spending.
There is speculation that there will be a tipping point where shale oil drillers will start to default once oil sustains a low price, but at what price $70 a barrel? $60? $50? Predictions about the lower price impact in the US vary, but it is estimated that if the average oil price falls to $60 per barrel, this could have a significant impact on Capex investment and the growth of shale oil production from an additional 1m daily barrel per year to around half that.
Another big winner is the global airline industry. Fuel is such a large component of its cost base that lower prices provide a huge boost to the industry and airline stocks in general.
Fuel subsidisers are also enjoying the benefits of lower oil prices. Countries such as India, Indonesia and Egypt who subsidise fuel for their citizens will see a positive budgetary impact, and they could use the opportunity to remove, amend or reduce these subsidies, which have eaten up an increasingly large part of government spending in recent years.
There are some producers who can be regarded as falling into the winning camp. Saudi Arabia has a low cost of production and can continue to pump at lower prices forcing out producers who have a higher cost base. The country needs a relatively high price to balance its budget, but with ¾ of a trillion USD in currency reserves is seen to have pockets deep enough to not blink first. Other producers who are winners are parts of the US shale industry who have used more efficient technology, low borrowings and extraction costs at around $40 a barrel so can be flexible and rapidly ramp production up or down.
Finally the global economy is a winner. It is difficult to quantify the exact impact of oil prices on the global economy, but it is possible to say that with lower oil costs consumers have additional funds to spend on items other than oil. This leaves more money in the pockets of the consumers, boosting the overall global economy.
In the losers’ camp we see in the main producers, who are receiving a lower price for their product. This is most significant for firms or sovereigns with a high cost of production, or sovereigns that are heavily dependent on oil revenues to balance their budgets even if production costs are not excessive. The countries most impacted will be Russia, Venezuela and Nigeria who need prices of more than $100 a barrel (and in Venezuela’s case considerably more) to keep government finances in order. Certain US shale producers who are highly indebted or need a higher price to break even will feel the pain, and be inclined to reduce quantities or exit the industry. Losers also include firms who are dependent on the industry’s growth, including drillers and oil equipment suppliers, who will see projects put on hold or cancelled if the breakeven point is not met.
Also on the losing side of the equation are those working in the market of renewable oil substitutes; their cost base is typically higher than the cost of oil production and these programmes will be impacted because they become less economical when the price of oil is lower.
There are so many variables with both economics and politics driving players making 2015 an exciting time to watch the global oil markets. Among the issues to watch are:
The potential for social and political unrest as well as changes in government. Countries that have become dependent on higher oil prices to balance their budgets will need a rapid return to higher prices or face shortcomings in their spending programmes.
The impact on the US shale oil market. Sustained low prices could inhibit future growth and job creation. There is a balancing act between the benefit to the US economy of lower oil prices and the investment and jobs created when the oil price is high enough to generate investment.
The impact on related industries. Higher oil prices in recent years have opened up whole new industries and enabled new sources and methods of oil extraction to come online as economically viable. Lower oil prices places a major question mark over their immediate future.