The recent drop in oil prices from $115 per barrel in June last year to $58 per barrel today (10th March) has asked the question why don’t oil producers cut back on supply? This would seem to be the logical policy to pursue as the revenue of oil producers has been cut significantly. However Saudi Arabia has allowed big oil surpluses to grow and as a result the price has fallen. As Saudi Arabia can extract the oil from the ground at a much lower cost than its oil producing counterparts they have a greater ability to absorb the lower oil price. Those that have a high cost of extraction – US shale producers, the tarsands of Canada, Russia, Venezuela – are now finding the return from oil is much lower. Therefore, the plan being to force high costs producers out of the market leading to an increase in the market share of the Gulf states.
Excess Oil Supply
There has been a growing amount of oil in storage which is absorbing the glut. World stocks have increased by approximately 265m barrels last year and is suggested to increase by a further 1.6m-1.8m barrels a day in the first six months of 2015 which adds about 300m barrels to the total. Oil producers are hoping that the demand for oil will increase next year and that the accumulated stock will satisfy that demand. However the restocking cannot continue for long as storage facilities in Europe and Asia are already at 80-85% capacity. Companies are going as far as renting oil tankers to store the excess oil. And what happens if storage facilities start to reach full capacity, then producers will be forced to dump supply onto the market dropping the price even further. There is the belief that oil prices will drop in the long run which will mean a restructuring of the industry.
Source: The Economist February 21st 2015
Over the last year oil prices have fallen by 55% with the price of a barrel of oil around the US$48 – see graph. China is the world’s second largest oil consumer (behind the United States) and largest net importer and is set to benefit from lower oil prices as consumers have more disposable income. Firms can also take advantage by reducing costs and boosting profits.
Since 1995 China’s oil consumption has been driven by the country’s rapid rate of growth especially in the manufacturing sector. By 2002 China had overtaken Japan as the second largest oil consumer. However oil’s share of China’s primary energy consumption has declined since this time – from 23% in 2002 to 18% in 2013 – as other energy sources have grown more rapidly. For most developed economies oil makes up approximately 37% of energy needs. China is still quite reliant on coal for around 70% of the country’s energy needs – see graph.
Last year China imported oil to the value of US$228bn which equates to 19% of total imports and 2.5% of GDP. With the lower oil prices there will be a reduction in money leaving the Chinese economy which should boost more domestic consumption.
Source: National Australia Bank
A widely used measure of the impact of oil prices on major producers’ governments is the fiscal breakeven price. That’s “the average price at which the budget of an oil-exporting country is balanced in a given year,” according to Standard & Poor’s. Estimates of fiscal breakeven prices can vary considerably based on a variety of factors including actual budget expenditures, and differences in oil production forecasts.
For most countries oil needs to be above $100 a barrel to balance the budgets of major oil producing countries. Venezula which has major deficit problems and accelerating inflation needs oil at $151 a barrel in 2015 to balance its budget. For Iran, which has yet to agree to curb development of nuclear weapons and heavily subsidizes gasoline for its citizens, needs oil at $131 a barrel. And Russia needs oil at $107 for a chance of getting its finances in order. As for Libya a whooping $317 per barrel is required for them to start to improve their fiscal position. See graphic below.
Back on deck after a good two week break. One issue that has been prevalent has been the drop in oil prices. The benchmark Brent crude oil price has fallen from US$115.65 on 19th June 2014 to US$56.42 today (4th January 2015) – that is a 51.2% drop. Why have prices dropped so much in such a short period of time?
The main reason for this is the increase in fracking where energy companies go deep into the ground and blast the shale rock with a mixture of water and chemicals which releases oil and gas to the surface. This technique has been particularly prevalent in US where production has increased from 5 million b/d in 2008 to nearly 9 million today. Ultimately the price has dropped because supply has outstripped demand. Of world production OPEC produces 30.3 million b/d and the rest of the world 61.8 million b/d. With this over supply you would expect OPEC countries to agree to reduce the volume of oil they pump everyday. However, according to Brian Gaynor in the NZ Herald, they are unwilling to reduce production for various reasons:
1. Most member countries are heavily dependent on oil export revenue
2. They have to meet interest costs on large government deficits
3. They believe that lower oil prices in the short term will discourage further investment in fracking and ultimately lead to higher long-term price for conventional oil.
Oil prices and world growth
The link between oil prices and the economic conditions of the global economy are well documented.
Low oil prices = booms periods in the global economy from 1948-1973 and 1993-2007
High oil prices = recessions – 1974-75, 1981-82, 1990-91, 2008-09
Low prices do stimulate growth – it means more spending power for consumers and it cuts cost for business. However the lower price will affect countries like Russia, Venezuela and Iran as they can only balance their books if the oil price is at US$100 a barrel or more. The US would be particularly affected by this lower oil price as much of the investment in fracking has been financed by high yielding but risky junk bonds. As the credit risk becomes greater with lower oil prices this could lead to sales by investors which would lead to illiquidity. According to The Observer newspaper “fracking could become the new sub-prime”.
With oil prices heading to below $60 per barrel and inflation on the rise the Russian economy is bracing itself for some difficult times ahead. Oil is imperative to Russian growth rates and The Economist reported that in 2007, when oil was $72 a barrel, the economy managed to grow at 8.5%. Additionally between 2010 – 2013, when oil prices were high, the country’s net outflow of capital was $232bn – 20 times what it was between 2004 and 2008. See graph from The Economist.
But as oil prices drop so does the currency which mean imports become more expensive – the bigger the drop the more expensive they are. Russia imports a lot of goods – the value in 2000 was $45bn compared to in 2013 $341bn. This lower value of the Rouble fuels inflation and it is expected to reach 9% by the end of the year. To maintain peoples spending power the government will need to intervene in the economy and run bigger deficits.
But there is another problem a weaker Rouble makes debt servicing more expensive so in the long-term more money needs to be found. When there was a high oil price instead of increasing their reserves, money was spent on salaries and pensions and especially the armed forces where spending increased by 30% since 2008. One wonders why they spent so much on the Sochi Winter Olympics. However drastic steps are being taken to reduce the decline of the Rouble with priests blessing the servers at the Central Bank with holy water.
Here is a useful clip from Al Jazeera which discusses the recent decision of the Organisation of the Petroleum Exporting Countries (OPEC) members to maintain the volume of oil pumped everyday even with the price of a barrel of oil falling from $110 to just over $80 this year. For Russia’s budget this can be a loss of revenue up $40bn – Russia, which is not an OPEC member, wants oil prices to go up but current EU sanctions over its role in Ukraine are hurting their request. OPEC members are attempting to find a solution regarding the slump as big oil producers like Saudi Arabia, Iran and Venezuela are continuing to see a loss in money.
Here is a useful image from The Economist and some comments that accompanied it:
Last 3 years has seen the lowest levels of price volatility in oil markets since the supply shocks of 1973 – (400% increase – 1979 – 200% increase. Partly due to stable production.
The reductions in oil supply with the sanctions against Iran and unrest in the Arab world have been offset by the increases in output from the shale boom in the USA.
Even with the take over off the largest oil refinery in Iraq by Islamist militants the price went to $114 a barrel compared to $147 during the financial crisis.
Last week I attended a PD for Teachers hosted by the University of Waikato Economics Department. Amongst the presentations was one on Developments in Environmental Policy. Questions were asked as to what is the Economic Way of Thinking about Pollution:
* What is the ‘efficient’ level of pollution?
* Rarely zero – choices have to be made* How should we get there?
* How can this be achieved at least cost?
* Who should bear the cost?
One particular example that was presented was the “Nutrient emissions reduction scenarios in the North Sea”. Ultimately for economists it is a cost benefit analysis with – Marginal Abatement Costs v Marginal Damage Costs (See graph below).
Theoretical representation of different management positions based on economic considerations and different interpretations of the precautionary principle (assuming that all cost can be expressed in monetary terms). Marginal abatement costs (ranging between AC1 and AC2) and marginal damage costs to the environment (ranging between DC1 and DC2) are shown
The letters on the horizontal axis represent the following:
A = Strict Precautionary Principle (As near as possible to pristine condition)
B = Precautionary Principle implemented through the best available technology
B – C = Safety Margin
C – E = Risk threshold zone of uncertainty
D = Implementation of the best available technology not entailed excessive costs for society
F – G = Economic Optimal zone
H = Implementation of the best available technology not entailing excessive private costs
Here are some statistics from The Economist on the oil industry in Nigeria.
* Nigeria produces 2.7m barrels a day
* 400,000 barrels of oil a day were stolen in April 2012
* $400bn of Nigeria’s oil revenue has been stolen or misplaced since independence in 1960
* Its 4 refineries work far below capacity, forcing Nigeria to import most of its fuel
* Government subsidies for petrol cost $16bn in 2011
* Fraud of $6.8bn has been exposed over a subsidy for petrol imports
* Pipeline sabotage accounts for more than 50% of the oil spills in Nigeria’s oil producing delta.
Regulatory uncertainty has assisted in making Nigeria’s oil industry stagnant – output is the same as it was a decade ago. However the major concern is that all this oil wealth should have benefited the population but the majority of them still live on less than $2 per day.