Over the past five years, prices of oil have hovered around $110 a barrel. As a result, oil men of North Dakota and Texas have completed almost 20,000 new wells since 2010, and this has greatly boosted America’s oil production to nearly 9m barrels a day (b/d). However, as demand is slowing due to weak economic activity, oil prices has fallen by more than 50% to $60 now. With annual inflation in China hitting a five year low, persistent weakness remains in the world’s largest energy consumer. Despite demand slowing globally, supply concerns remained as Saudi Arabia and its Gulf OPEC (Organization of Petroleum Exporting Countries) allies are still showing no signs of cutting output to boost oil prices. Analysts have warned that significant factors of oversupply and low demand in major economies such as India and China will continue to weigh on oil prices. Lower prices however, will be a boost to oil-importing countries worldwide. Whether how long the prices stay low and if it is possible to recover in 2015 is what I will be analyzing and investigating based on critical information presented. This article will also be assessing on the internal and external environment that would affect OPEC and the shale-drillers. Inference will then be drawn with a brief discussion from my analysis.
OPEC is a permanent intergovernmental Organization that was founded in 1960. Its objective is to coordinate and unify the petroleum policies among member countries, in order to secure fair and stable prices for petroleum producers; an efficient, economic and regular supply of petroleum to consuming nations; and a fair return on capital to those investing in the industry (OPEC, 2015). With a world population of 7 billion, there is indeed ample opportunity for stimulating further economic growth globally.
Oil is an important part of the larger global energy market, which is expected to see continued consumption growth largely in emerging markets, especially China. As technology accelerates through horizontal drilling and hydraulic fracking of oil, high oil prices have made fracking oil/gas in U.S. a lucrative investment. With two main rivals in the market now, namely the U.S. and member countries in OPEC, competition between increased U.S. domestic crude oil production and OPEC’s decision to maintain current export levels has resulted in the production of more oil than what the market had expected.
Image credits: The Economist
“With two main rivals in the market now….. competition has resulted in the production of more oil than what the market had expected.”
With a combination of major countries’ economies slowing, stagnating demand for oil, increased U.S. domestic crude oil production and OPEC’s decision to maintain current export levels, excess oil supply has led to the recent 50% market price decline (Miller, 2014). The economics of oil is now beginning to change. America’s shale has proven to be a genuine rival to Saudi Arabia, the single largest oil exporter and de facto OPEC leader (The Economist, 2014).
Falling oil prices has negative and positive impacts in the U.S. For many people, cheaper oil prices offer an excellent economic boost as fuel now cost cheaper than before. Falling oil prices have also the recent sensation of resurging economic growth in the U.S. where this decline is behind a “positive supply shock” which leads to the recent boost in economic activity and decline in unemployment (Hartley, 2015).
Domestically, lower oil prices would mean that there is now more disposable income to spend. This savings can be translated to higher consumption for retail spending and travel where airlines may pass the lower cost to consumers as well. Analysts have estimated that higher consumer spending should boost U.S. Gross Domestic Product (GDP) by 0.4%-0.5% this year (Quora, 2015).
According to Rajiv Biswas, Asia Pacific chief economist at international consultancy IHS, said “the slump in world oil prices represents an estimated transfer of around $1.5 trillion from global oil producing countries to oil importing countries, and Asian oil importing industrial nations are among the biggest winners.” The plunging oil prices now offer politicians around the world to vindicate energy policies.
India imports 75% of oil and analysts have mentioned that falling oil prices could ease their current deficit and at the same time, allow the cost of India’s fuel subsidies to fall by an estimate of $2.5 billion this year (The Economist, 2015). This will definitely allow cash strapped countries such as India and Indonesia to cut back on fuel subsidies to free up money to spend on hospitals and schools.
Japan on the other hand, considers lower oil prices as a mixed blessing. While lower oil prices may ruin Japanese Prime Minister Shinzo Abe’s growth strategy to combat deflation with high energy prices (Bowler, 2015), each 1% drop in crude prices is equivalent to saving billions of dollars.
Similarly, China is largest importer of oil. Based on 2013 figures, every $1 fall in oil prices would result in a saving of $2.1 billion and the recent fall, if sustained, may help China to save at least $60 billion (Anonymous 2014). This is likely to increase their GDP assuming the rest of the elements in the equation remains unchanged. Cheaper oil prices may also help the Chinese government to clean up China’s filthy air by eliminating dirty vehicle fuel, such as diesel. Lin Boqiang of Xiamen University has also mentioned in The Economist that lower prices should support the government’s efforts to reduce subsidies on fuel prices. Nonetheless, lower oil prices may not fully offset the far wider effects of a slowing economy.
Despite several members of the OPEC wanting to cut its output in hope of pushing the price back up again, Saudi Arabia is indirectly pushing for a different tactic: to let prices fall which in turn pushes high cost fracking shale drillers out of business. This may be proven true where a shake-out is already on its way (The Economist, 2014). Even before oil prices started falling, most were already investing in more new wells than they were making from their existing ones. With revenue falling fast, bankruptcies are not unlikely. From an academic viewpoint, oil producers with higher costs of production will be forced to shut down to the point where demand and supply is at an equilibrium again. This is the reason why Saudi Arabia is maintaining OPEC’s current level of production, despite the pain it might be causing to other OPEC members – The Saudis want to force out the shale oil producers in U.S. to shut down because the U.S. generally have a higher cost of production than Saudi Arabia’s conventional drilling (Quora 2015).
Russia is one of the world’s largest oil producers and its economy relies heavily on energy revenues, with oil and gas accounting for approximately 70% of their export revenues (Bowler 2015). The recent near 50% plunge in oil prices has caused Russia to lose about $2 billion in earnings for every dollar fall in the oil price. Economists have estimated that Russia’s GDP will expect to shrink at least 4.5% in 2015 if oil stays at $60 per barrel (Plumer 2015). Saudi Arabia also has $900 billion in reserves, hence it can tolerate lower oil prices quite easily (E.L. 2014). Furthermore, its own oil cost very little to get out of the ground (around $5-$6 per barrel). As a result, neither of the OPEC members are willing to cut production to push prices for fear that this will cause importers to increase their production and OPEC members would ended up losing their niche market. This continued decrease in oil prices would also force some higher cost oil producers out of the market, which is likely to be one of the reasons why OPEC and its Gulf allies are not budging.
However, not all OPEC members share similar low costs in digging oil out from the ground. Energy sales in Nigeria, Africa’s biggest oil producer, accounts for up to 80% of government revenue and more than 90% of the country’s exports. Yet decreasing oil prices means it is getting difficult for OPEC members such as Iran, Iraq and Nigeria to yield a sustainable amount of income inflow. With larger population sizes in relation to their oil revenue, these countries do need oil prices to be above $120 a barrel to avoid hard spending choices.
Another country that could suffer due to falling oil prices would be the U.S. as well. A growing surplus of domestic oil in the U.S. have caused oil imports to drop and as a result, cause oil prices to fall. With oil prices down, so are profits. As fracking from oil/gas from mile-deep shales is expensive, recent analysis from Scotiabank estimates that frackers need $69 barrel of oil to make money. Amercian frackers have borrowed heavily on the expectation of continuation of the high oil prices and these include Western oil companies with high cost projects. Firms like Texas’ Permian Basin are withdrawing and even though not everyone is leaving, the number of US rigs have fallen by 15% from December to January (Plumer 2015). Despite wells that are currently pumping can survive low market prices because they have already incurred start up and drilling costs, low oil prices diminish the incentive to invest in new well investment (Dimick 2014). Many U.S. shale oil producers need to carry on pumping in order to generate some form of income stream to pay off debts and other sunk costs. This may indeed looks like a sign that a continued surplus of oil production and low prices are going to stay in the longer term.
Oklahoma Employment Security Commission Chief Economist Lynn Gray mentioned that continued low oil prices is going to increase the burden on the momentum that continued low prices is going to increase the burden on the momentum of the state’s economy and job market (Weiss 2015). As jobs in the oil industry pays a well-above average, falling oil prices across the economy while wages remain the same would mean that firms’ margin would be compromised and employment will either become stagnant or decline. Layoffs due to lower profits is going to have a strong multiplier in the economy. While unemployment has yet to be visible, it is unlikely that the oil industry would hire more people in the near term. This would result in lesser people working in plants and each employed worker would experience heavier responsibilities as they may now need to cover the job scope of more than one person. This was indeed beginning to show when nine plants of United Steelworks in Philadelphia, U.S. have been going on strike since Feb 1, 2015 (DePhillis 2015). Doan and Powell from Bloomberg Business have reported that work has come to a halt which began on Feb 1, 2015 at nine sites from California to Texas and expanded to two BP Plc refineries in the Midwest to twelve refineries and three other facilities.
Although strikes has happened in the U.S., it is not unlikely that these strikes would not spread across to other OPEC countries. As mentioned above, it is becoming increasingly difficult for countries like Iran, Iraq and Nigeria to yield a sustainable amount of income inflow. Hence, dismissing workers is not entirely impossible. With work stoppage, it is likely that the supply of oil may began to recover to a state where it is able to meet current demand and perhaps even allow demand to exceed supply causing a temporary surge in oil prices again.
It is very difficult to predict whether global oil prices will stay low or otherwise because if oil demand is still weak and production stays high, then it is highly likely that prices might not bounce back for some time. Furthermore, the world is full of surprises. China may come roaring back and Saudi Arabia may decide to call it quits and cut back on production; all of which could send prices rising again. However, one undeniable thing is that with low oil prices, OPEC does run the risk of splitting up despite its vast resources especially if Saudi Arabia remains set on maintaining current output at the expense of other OPEC members. Many of the world’s consumer-producer relationships have also been influenced in some way by America’s new role as a top energy producer (Domm 2014).
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