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FALL IN PETROLEUM PRICES Has the economics of oil changed

bsc chronicle feb 2015

Has the economics of oil changed?
    The oil price has fallen by more than 40 per cent since Jun, when it was $115 a barrel.  It is now below $60.  This comes after nearly five years of stability.  At a meeting in Vienna on 27 Nov. the organization of Petroleum Exporting Countries (OPEC), which controls nearly 40 per cent of the world market, failed to reach agreement on production curbs, sending the price tumbling.
    Why is the price of oil falling?  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.  But it can also weather a low price.  Moreover, history suggests most of the gains from any cut in its output would go to other producers.  Saudi Arabia did try the tactic in the early 1980s, cutting its output from 10m barrels per day in 1980 to under 2.5m in 1985-1986.  The result was higher prices, but also a boom in investment, and then production, in places such as Britain and Norway.
     Trying to save OPEC with such tactics could be even more dangerous now.  Keeping the price up would be good news for frackers, speeding the spread of that technology from America to other countries.  Costly oil spurs thrift too, hastening the shift away from oil in transport.  Every hybrid or electric car spells lost business for oil producers.  Why encourage them?
    Cheap oil also has its consolations.  Russia and Iran, two countries with which Saudi Arabia has its differences, are suffering much more.  Better still, if low prices stem investment in other sources of oil, such as Canada’s tar sands or America’s shale, it means more demand for low-cost Saudi oil in future.
    Cheaper oil should act like a shot of adrenalin to global growth.  A $40 price cut shifts some $ 1.3. tn from producers to consumers.  Big importing countries such as the euro area, India, Japan and Turkey are enjoying  especially big windfalls.  Since this money is likely to be spent rather than stashed in a sovereign-wealth fund, global GDP should rise.  The falling oil price will reduce already-low inflation still further, and so may encourage central bankers towards looser monetary policy.  The Federal Reserve will put off raising interest rates for longer; the European Central Bank will act more boldly to ward off deflation by buying sovereign bonds.
     There will, of course, be losers, Oil-producing countries whose budgets depend on high prices are in particular trouble.  The trouble tumbled as Russia’s prospects darkened further.  Nigeria has been forced to raise interest rates and devalue the naira.  Venezuela looks ever closer to defaulting on its debt.  The spectre of defaults and the speed and scale of the price plunge have unnerved financial markets.  But the overall economic effect of cheaper oil is clearly positive.
   Just how positive will depend on how long the price stays low.  That is the subject of a continuing tussle between OPEC and the shale-drillers.  Several members of the cartel want it to cut its output, in the hope of pushing the price back up again.  But Saudi Arabia, in particular, seems mindful of the experience of the 1970s, when a big leap in the price prompted huge investments in new field, leading to a decade – long glut.  Instead, the Saudiseem to be pushing a different tactic; let the price fall and put high-cost producers out of business.   That should soon crimp supply, causing prices to rise.
    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.  Third, 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.
    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 (already hit by Western sanctions) and Iran (which is paying to keep the Assad regime afloat in Syria).

FALL IN PETROLEUM PRICES Has the economics of oil changed Reviewed by sambasivan srinivasan on 7:57:00 AM Rating: 5

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