Oil markets are dangerously rebalancing as prices fall
Cheap oil will be a boon for consumers, but carries long-term risks too
The bonanza years for oil producers are over. The fall in oil prices since the summer shows no sign yet of stopping. Industry veterans talk darkly of a return to the barren years of 1990s or the glut of the 1980s. Pessimism is spreading across the sector.
As Petroleum Economist went to press, the front-month Brent contract was selling for around $65 a barrel and WTI for $62/b. Wall Street price forecasts for 2015 are being rewritten daily. The market has further to fall.
Prices may not drop as dramatically, or land as low, as they did in the second half of 2008. But there are few indications that once Brent has bottomed, probably sometime next spring, perhaps in the $50s, it will enjoy the kind of recovery seen in 2009, either.
The global financial crisis was responsible for the price collapse in crude markets in 2008. This time, raw fundamentals of supply and demand are largely to blame and will be harder to change. High oil prices over the past few years have weakened consumption growth while unleashing an unstoppable torrent of fresh supply. Consider that in the first nine months of 2014, Texas on its own almost added enough extra oil supply to account for total global demand growth for the entire year. Or that added supply from the US between 2011 and 2013 exceeded the rise in global demand in those years.
Lower oil prices should temper the pace of US supply growth in 2015, but not by much. Opec’s decision in November to keep its ceiling unchanged – an implicit invitation to the market to start selling hard – was a strategy devised by Saudi Arabia to kill off US marginal oil output and regain the market share Opec has been shedding in the past three years.
But the shock therapy is not working yet. The Energy Information Administration expects US tight oil output to keep rising next year, even if activity slows. Companies will focus on better quality wells, of which more than 600 remain to be completed, according to Citi, a bank. This may bring another spurt in production. It remains to be seen if Opec has the stomach to endure the sustained low oil price that will squeeze out rival supply.
Even cheaper oil will be needed to balance the market, especially in the second half of 2015 when demand will be lower than in the last quarter of 2014. On 10 December, Opec said the call on its oil in 2015 would be just 28.9 million barrels a day, or 300,000 less than its previous forecasts. To hold onto market share, the group’s Gulf producers have slashed, again, the price of the oil they sell to the US and Asia. Members like Libya, Iraq and Iran may even see output rise significantly in 2015.
For those of us who don’t export oil, the falling price seems like good news. Household spending power will rise as fuel costs fall, spurring domestic retail demand and liquidity in many big consumer countries, though this impact will vary. High fuel duties in European countries -- almost 60% of the cost of gasoline in the UK is tax -- mean the price drop on the forecourt will be less than elsewhere. In the US, by contrast, just over 14% of the price is tax. The Automobile Association of America says the average gallon now sells for about $2.60. It will get cheaper. Goldman Sachs reckons this will equate to a $75bn tax cut for Americans and could increase their country’s economic output by 0.4 percentage points. UBS, another bank, says a $10/b drop can be worth 0.2 percentage points for global GDP.
Yet a price slump will do nothing to help re-inflate Western economies, making efforts to beat back rising debt loads more difficult. The plummeting stock value of energy firms will drag other shares down, too, weakening markets. Dividend payments from big oil companies are critical to many pension funds. As Opec revenue drops in the coming months, the petrodollars that have buoyed US treasuries, global equity, real estate and bond markets will dwindle. It wasn’t just producer economies that got used to high oil prices -- consumer economies increasingly to relied on them too.
Other disasters are in the making. For some new oil regions, such as East Africa, the plunging price will dampen hopes for upstream investment and new, much-needed government revenue, because explorers will find it harder to raise money. For every oligarchic oil-rich exporter, there are as many impoverished countries that need petroleum revenue. For rich-world producers like Alberta and Norway, the adjustment to a prolonged oil-price slump will be managed peacefully, albeit with tighter spending. For Iraq, barely holding together under the Islamic State’s onslaught, the crumbling of its finances -- needing $106/b to break even -- threatens an implosion. Venezuela, Russia, Iran, Algeria, Nigeria and others all face deficits, bankruptcy or the rapid depletion of reserves amassed in recent years. Social unrest is more likely as their economies disintegrate. Recession in emerging markets would hurt economies beyond their borders.
It remains to be seen if Opec has the stomach to endure the sustained low oil price that will squeeze out rival supply
As oil firms rein in capital spending plans and big projects cancelled or shelved – starting in the deep water, the oil sands and other pricey areas - the consequences will eventually be felt far beyond the oil sector. The seeds of the next damaging price spike are being laid as a temporary glut tells companies to cut spending in the upstream.
Equally bad could be the impact on demand. Years of oil at around $100/b forced consumers to use oil more carefully and supported the rise of alternative fuels in transport. Secular trends towards conservation have taken root, especially in Western countries. In the US, miles driven (adjusted for population growth) have fallen by almost 10% since 2005. New fuel-economy standards are in place globally that will make vehicles drive each mile on less fuel.
Climate legislation has been one force behind these changes. But high oil prices added political momentum to the fight against climate change and made conservation a sensible consumer choice.
Just as strong crude prices unleashed a new torrent of supply while telling consumers to use oil more sparingly, a plummeting price threatens to do the opposite. So despite the short-term benefit about to come consumers’ way, they should be cautious. The pain of the market’s correction will be felt first among the producers, from Alberta to Siberia and Baghdad. But depressed upstream spending and revived demand growth will eventually bring back older problems, too. It was the cheap oil of the late 1990s that laid the seeds for the damaging spike a decade later.