Eight things you need to know about falling oil prices


Vivek Kaul

The price of oil has been falling for a while now. As I write this the brent crude oil is selling at around $80.4 per barrel. There are several reasons behind the fall and several repercussions from it as well. Let’s look at them one by one.

1) The Chinese demand for oil has not been growing at the same rate as it was in the past, as Chinese economic growth has been falling. As Ruchir Sharma, head of Emerging Markets and Global Macro at Morgan Stanley Investment Management wrote in a recent column in The Wall Street Journal “The growth rate in Chinese demand for oil has plummeted to nearly zero this year, down from 12% in 2010. This is arguably the main reason why oil prices are down.”
2) In the past when oil prices fell, the Organization of Petroleum Exporting Countries (OPEC) led by Saudi Arabia used to cut production to ensure that supply fell and that ensured that prices did not continue to fall. This hasn’t happened this time around. As the Saudi oil minister Ali Naimi told Reuters on November 12, “Saudi oil policy has been constant for the last few decades and it has not changed today.” He added that: “We do not seek to politicise oil…for us, it’s a question of supply and demand, it’s purely business.”
And what is this pure business Al Naimi is talking about? The United States and other western nations like Canada have had a boom in shale oil production. This boom has led to the United States and Canada producing much more oil than they were a few years back. Data from the U.S. Energy Information Administration shows that United States in 2013 produced 12.35 million barrels per day. This is a massive increase of 35% since 2009. In case of Canada the production has gone up by 22.8% to 4.07 million barrels per day between 2009 to 2013.
Shale oil is very expensive to produce and depending on which estimate one believes it is viable only if oil prices range between $50 and $75 per barrel. Hence, by ensuring low oil prices the Saudis want to squeeze out the shale oil producing companies in Canada and United States.
3) So is the Saudi policy working? The US Energy Information Administration in its latest Drilling Productivity Report said that the seven largest shale oil companies will produce 125,000 barrels more per day in December 2014 in comparison to November 2014.
Hence, the Saudi strategy of driving down oil prices to ensure that the production of oil by shale oil companies is no longer viable, hasn’t seemed to have had an impact yet. Nevertheless that doesn’t mean that a fall in oil prices will have no impact on shale oil production.
International Energy Agency (IEA) has said that the investment in shale oil fields will fall by 10% next year, if oil prices continue to remain at $80 per barrel. Faith Bristol, chief economist of IEA recently said “there could be a 10 per cent decline in US light tight oil, or shale, investment in 2015 [from full-year 2014 levels]”…I wouldn’t be surprised to see statements from different companies in the weeks and months to come [outlining a change in] their investment plans and reducing budgets for investments in North America . . . especially the United States.” And this will have an impact on the production of shale oil in the medium term, if Saudis continue to sustain low oil prices.
4) Nonetheless, the interesting thing that the United States and other Western nations may never have to increase production of shale oil, just the threat of doing that will act as an insurance policy. As Niels C. Jensen writes in the Absolute Return Letter for November 2014 “There is nothing easier to get used to in this world than higher living standards, and the populations of most oil producing nations have seen plenty of that in recent years. Shale [oil] is a threat against those living standards, and falling oil prices are the best assurance they can hope for that shale [oil] will never become the major production factor that we are all being told that it could become. It is very expensive to produce and thus requires high oil and gas prices to be economical.”
But even with that shale oil can act as an insurance policy against high oil prices, feels Jensen. As he writes “In a rather bizarre way, shale [oil] has thus become an insurance policy, as the western world never have to ramp up shale production to levels that have been discussed. The sheer threat of doing so should keep the oil price at acceptable levels.”
5) Also, low oil prices are going to benefit nations which import oil. “A $20-per-barrel drop in oil prices transfers $6-700 billion from oil producing nations to consumers worldwide or nearly 1% of world GDP. Assuming consumers will spend about half of that on consumption, which historically has been a fair assumption, the positive effect on GDP in consumer countries is 0.5%,” writes Hunt. And this is clearly good news for oil importing nations like India. Falling oil prices are also benefiting airlines and shipping companies given that oil is their single biggest expense.
6) News reports suggest that China is using this opportunity to buy a lot of oil. As a recent report on Bloomberg points out “The number of supertankers sailing toward China’s ports matched a record on Oct. 17 and is still close to that level now.”
7) The countries that are likely to get into trouble if oil prices continue to remain low are primarily Russia and Iran. Russia relies heavily on exports of oil and gas. As a recent article on cnbc.com points out “In 2013, for example, Russia’s energy exports constituted more than two-thirds of total exports amounting to $372 billion of a total $526 billion.” Further, the Russian government’s budget gets balanced (i.e. its income is equal to its expenditure) at an oil price of anywhere between $100-110 per barrel. Iran’s case is similar. Hence, both these countries need higher oil prices.
As a recent Oped in the Los Angeles Times points out “Russia and Iran compete with Saudi Arabia in the international oil market, and both need oil prices to be at roughly $110 a barrel in order to balance their budgets. If oil prices remain at $80 a barrel, the strategic ambitions of Tehran and Moscow could be severely undermined.”
8) Saudi Arabia also gets hit by a lower oil prices. “Saudi produces close to 10m barrels per day, similar to Russian output. A $20 fall in the oil price, costs Saudi Arabia about $200m per day,” a recent article in The Independent points out.
But Saudi Arabia has more staying power than the others. The fact that
Aramco (officially known as Saudi Arabian Oil Company) has deep pockets is a point worth remembering. As Vijay Bhambwani, CEO of BSPLIndia.com recently told me “Saudis can produce low cost arab light sweet crude very cost efficiently and only the recent state welfare schemes implemented after the arab spring, have raised the marginal costs. Even a slight rollback / delayed released of the additional welfare payments (US $ 36 billion) can add sizeable cash flow into the Saudi national balance sheet and give it additional staying power.”
To conclude, there are many different dimensions to falling oil prices and the way each one of them evolves, will have some impact on oil prices in the days to come .

The article originally appeared on www.FirstBiz.com on Nov 13, 2014

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)