Slippery oil

Falling oil prices and their effects

This is what a collapse looks like. In just 18 months the oil price has fallen by 75% from $110 a barrel to below $27. But where’s the bottom? Morgan Stanley says $20, RBS says $16, Standard Chartered $10! It’s a boon for drivers, a tax break for consumers but the force of the decline so far is so fast that it is destabilising the world economy.

When Brent last broke through a $100 in September 2014, US Shale oil production was soaring, OPEC output was boosted by Libya (740,000 bpd) and Chinese demand was waning. Four months later the Brent was edging below $50.

So where do we go from here? We know that oil-producing nations like Iraq, Venezuela and Nigeria are under pressure but now even Saudi Arabia is feeling the pinch as it is being forced to cut spending. Pink slips are on rise for energy workers and potential bankruptcy for oil companies. Four reasons why it is happening:

First, OPEC won’t cut production. The world’s largest oil producers are whole mount to see if other smaller producers will bolt their pumps, hoping that they would gain or increase their market share in the long run but it is costing them billions. OPEC crude oil production averaged 31.6 million b/d in 2015, an increase of 0.9 million b/d from 2014. Iraq led the OPEC production increases as their production rose by 0.7 million b/d in 2015. Saudi Arabia also boosted production to defend its share of the global oil market, with its production increasing by 0.3 million b/d in 2015. Now, Iran is all set to join this predatory price war. Iran is expected to increase production once international sanctions targeting its oil sector are suspended. Under the Joint Comprehensive Plan of Action (JCPOA) between Iran and the five permanent members of the United Nations Security Council and Germany (P5+1), which was announced on July 14, 2015, sanctions relief is contingent on verification by the International Atomic Energy Agency (IAEA) that Iran has complied with key nuclear-related steps. The forecasted OPEC crude oil production is expected to increase by 0.6 million b/d till the start of 2017, with Iran accounting for most of this increase.

Two, China is spooking everyone. The world’s second largest economy is slowing, it needs less fuel to run its economy and emerging markets would need less as well. Consumption of petroleum and other liquid fuels in countries outside the Organisation for Economic Cooperation and Development (OECD) increased by an estimated 0.8 million b/d in 2015, considerably lower than the 1.4 million b/d increase in 2014 mainly because of the slowdown in Eurasia, which saw a contraction in its consumption, and to a lesser degree because of China’s slightly slower demand growth.

Third, the US is producing more oil than ever. Largely created by the America’s shale oil boom and a plunge in prices haven’t shut out many producers yet. At the corporate level, Exxon Mobil, Shell, Chevron and Statoil have all reduced investments. Although oil companies have reduced investments, most of the cuts have been in capital exploration budgets that largely affect production levels of the future. Conoco Phillips loses close to $2 billion each quarter for every $10 drop in oil prices, according to Barclays. Last week with Brent hopping around $30, British Petroleum announced that it would cut around an additional 4,000 jobs highlighting the pressure on oil majors. US Energy Information Administration (EIA) estimates that petroleum and other liquid fuels production in countries outside of the Organisation of the Petroleum Exporting Countries (OPEC) grew by 1.3 million b/d in 2015. The 2015 growth occurred mainly in North America.

And finally, US dollar is strong. Crude oil is traded in dollars which means when the dollar gets stronger, the oil gets more expensive for overseas buyers, which hurts demand and drives the prices down further. Because oil revenues are denominated in dollars, the appreciation of the dollar relative to the currencies of several large oil producers means each dollar of revenue has more purchasing power if production costs are denominated in local currency.

Of course cheap oil also comes with a lot of benefits; India, Egypt and Indonesia have all been able to slash fuel subsidies worth almost $500 billion since 2014, according to International Energy Agency. Airlines are getting a boost, as are car markers and it is a positive for consumers unless, of course, falling prices lead to deflationary cycles that adds to another headache for central bankers.