The Slippery Slope : Oil & Gold

[Economics Club IIT Delhi]

Introduction

The oil price has fallen by more than 40% since June, when it was $115 a barrel. It is now below $70. This comes after nearly five years of stability. At a meeting in Vienna on November 27th the Organisation of Petroleum Exporting Countries (OPEC), which controls nearly 40% of the world market, failed to reach agreement on production curbs, sending the price tumbling. Also hard hit are oil-exporting countries such as Russia (where the rouble has hit record lows), Nigeria, Iran and Venezuela. Why is the price of oil falling and what are its implications?

Why are the Oil Prices taking a tumble?

The oil price is partly determined by actual supply and demand, and partly by expectation. Demand for energy is closely related to economic activity. It also spikes in the winter in the northern hemisphere, and during summers in countries which use air conditioning. Supply can be affected by weather (which prevents tankers loading) and by geopolitical upsets. If producers think the price is staying high, they invest, which after a lag boosts supply. Similarly, low prices lead to an investment drought. OPEC’s decisions shape expectations: if it curbs supply sharply, it can send prices spiking. Saudi Arabia produces nearly 10m barrels a day—a third of the OPEC total.

Four things are now affecting the picture. Demand is low because of weak economic activity,increased efficiency, and a growing switch away from oil to other fuels. Second, turmoil in Iraq and Libya—two big oil producers with nearly 4m barrels a day combined—has not affected their output. The market is more sanguine about geopolitical risk. Thirdly, America has become the world’s largest oil producer. Though it does not export crude oil, it now imports much less, creating a lot of spare supply. Finally, the Saudis and their Gulf allies have decided not to sacrifice their own market share to restore the price. They could curb production sharply, but the main benefits would go to countries they detest such as Iran and Russia. Saudi Arabia can tolerate lower oil prices quite easily. It has $900 billion in reserves. Its own oil costs very little (around $5-6 per barrel) to get out of the ground.

Recent Developments

The Saudis have made it clear, by what they have said and what they have not done, that they want the U.S. and others to cut production before they do any cutting of their own. This is the end of OPEC as we have known it, and it will keep the global oil market chaotic for some time.

Alternate Sources of Oil

Most of the world’s new oil production has come from U.S. shale fields and Canadian tar sands —two main forms of “tight oil” that were made possible by new technologies that had revolutionized the industry. Both are relatively high-cost sources of oil, but with an important difference. The tar sands projects require huge initial investments in processing plants but have low marginal costs to operate afterward. Once established, their production is unlikely to change much. By contrast, shale fields produce most of their output in the first year, which makes their output highly responsive to oil prices. A disproportionate amount of any reduction in global supply is therefore likely to come from cuts in U.S. shale oil production.

The Implications

->The Downside

The main effect of this is on the riskiest and most vulnerable bits of the oil industry. These include American frackers who have borrowed heavily on the expectation of continuing high prices. They also include Western oil companies with high-cost projects involving drilling in deep water or in the Arctic, or dealing with maturing and increasingly expensive fields such as the North Sea. But the greatest pain is in countries where the regimes are dependent on a high oil price to pay for costly foreign adventures and expensive social programmes. These include Russia (which is already hit by Western sanctions following its meddling in Ukraine) and Iran (which is paying to keep the Assad regime afloat in Syria). Optimists think economic pain may make these countries more amenable to international pressure. Pessimists fear that when cornered, they may lash out in desperation.

On the demand side, lower oil prices will weaken the incentives for a more fuel efficient capital stock. The high fuel prices of the past several years had moved the airlines to order more fuel-efficient planes and tilted consumers to more fuel-efficient cars. But by late last year, airlines were cancelling new plane orders and car sales of SUVs and light trucks soared. These effects will be modest. They will not undue the environmental movement toward fuel efficiency, but will delay some change.

Some of the effects are welcome, others not. For Russia, whose budget depends heavily on oil revenues, the decline in oil prices is a financial disaster. The ruble’s foreign exchange value has already been cut in half. Terrorists in the Middle East arm themselves with revenue from oil. In the U.S., the development of shale fields has often been funded with credits that are held by banks and high-yield bond funds. Many of these credits could default.

-> The Upside

The unambiguous positive effect of lower oil prices will be for the boost they provide to the purchasing power of the world’s consumers at a time when such stimulus is badly needed.

What are your views on this?