Oil prices are at a 4 year-low now but assuming that they will continue to fall is risky business

 oil

Vivek Kaul

Oil prices have been falling for a while now and have now touched a four year low. As per the data published by the Petroleum Planning and Analysis Cell, the price of the Indian basket of crude oil touched $ 82.83 per barrel on October 16, 2014.
There are several reasons for the fall (You can read about them in detail
here and here). Analysts expect this growth to continue to fall in the years to come. Several fundamental reasons have been offered as an explanation for the same.
As Crisil Research points out in a research report titled
Falling crude, LNG, coal prices huge positive for India “Over the next five years, we expect global oil demand to increase by 4-4.5 million barrels per day (mbpd). However, crude oil supply is expected to increase by 8-10 mbpd. This, we believe, will bring down prices from current levels.”
This augurs well for India as falling oil prices will ensure that the under-recoveries suffered by the oil marketing companies(OMCs) on selling diesel, cooking gas and kerosene, will fall. The government has been compensating the OMCs for these under-recoveries. Falling under-recover will mean lower government expenditure leading to a lower fiscal deficit. Fiscal deficit is the difference between what a government earns and what it spends.
Analysts Harshad Katkar and Amit Murarka of Deutsche Bank Markets Research in a report titled
Breaking Free point out that “Fuel subsidy could fall to an annual level of $7billion – a 70% reduction over financial year 2014 – by financial year 2020 and potentially reduce the government’s fuel subsidy burden to zero by 2021 driven by elimination of the diesel subsidy and rationalization of the cooking fuel subsidy.”
These arguments sound pretty good. The only problem is that predictions on which direction oil prices are headed invovle too many variables and predicting all these variables at the same time is not an easy thing to do.
On several occasions in the past, well renowned experts have ended up with eggs on their face while trying to predict the price of oil. In January 1974, the Organization of Petroleum Exporting Countries (OPEC) raised the price of oil to $11.65 per barrel. This was after OPEC’s economic commission had determined that the price of oil should be $17 per barrel.
It was around then that the economist Milton Friedman wrote in a column in the
Newsweek magazine where he predicted that “the Arabs … could not for long keep the price of crude at $10 a barrel.”
By early 1981, the price of oil had risen to $40 a barrel. A spate of reasons including the politics of the Middle East were responsible for this rise. Other than the politics of the Middle East, in April 1977, the Central Intelligence Agency (CIA) of the United States had come up with a highly influential report which predicted that the growth of the world oil demand would soon outpace production.
This was primarily because of constraints on the OPEC production. The Soviet Union, another big oil producer, would reach its peak soon. This meant that by the mid-1980s, oil would become very scarce and expensive, the report pointed out.
Customers, including some of the biggest international oil companies, were queuing up to buy oil. The report succeeded in generating sufficient paranoia among the oil-consuming nations as well as the big oil-producing companies. Hence, they wanted to buy as much oil as they could.
All the doomsday predictions regarding the price of oil turned out to be wrong. By 1983, the average OPEC price had fallen to $28 per barrel leading to some members of OPEC offering additional hidden discounts in an attempt to boost their stagnating sales.
By 1986, the price of oil was quoting again at $10 a barrel, proving the CIA prediction to be all wrong. Milton Friedman, though, was right about the price in the end. And Friedman would write a “I told you so” column in
Newsweek which appeared on March 10, 1986, titled “Right at Last, an Expert’s Dream.” This, of course, was in jest. As Friedman confessed, “Timing, as well as direction, is important…I had expected the price of oil to come down far sooner.”
What this tells us is that it is very difficult to predict the long term direction of the price of oil. One reason why oil prices have not risen in the recent past despite the rise of Islamic State of Iraq and Syria (ISIS) is because the outfit has not been able to move into the southern part of Iraq where a major part of the country’s oil is produced. Southern Iraq is dominated by the Shias who do not support the ISIS.
Then there is the so called deal between Saudi Arabia and the United States, where the ruling dynasty of Saudi Arabia is believed to have engineered a fall in the price of oil so as to ensure that the security guarantee that they have from the United States, continues.
The trouble is that with the price of oil now lower than $85 a barrel, the shale oil boom that is happening in the United States and Canada, might not be able to continue. Shale oil is expensive to produce and it is financially viable only if the price of oil remains at a certain level. As analysts of Bank of America-Merrill Lynch point out in a report titled
Does Saudi want $85 oil? “With production costs ranging from $50 to $75/bbl at the well head, a decline in Brent crude oil prices to $85 would likely be a major blow to US shale oil players and lead to a significant slowdown in investment.”
The shale oil boom can lead to a situation where the United States no longer needs to depend on the Middle East and other countries to meet its oil needs. Hence, to some extent it is in the interest of the United States that oil prices continue to fall. At the same time, one reason that dollar continues to be the international reserve currency is because oil continues to be bought and sold in dollars.
Saudi Arabia over the years has cracked the whip among the OPEC nations to maintain a status quo on this front. It is in the interest of the United States that the dollar continues to be the international reserve currency. While every country in the world needs to earn dollars, the United States can simply print them.
And to ensure that dollar continues to be a reserve currency, the United States, needs Saudi Arabia on its side. The Saudis currently would prefer a lower price of oil, in order to make the production of shale oil unviable. At the same time they would like the security guarantee they have from the United States to continue, in order to protect them against the ISIS.
As the Bank of America-Morgan Stanely analysts point out “It should perhaps not come as a surprise that the threat of a stateless group that challenges the status quo by attempting to redraw national borders is shifting incentives for key regional and global players…The Islamic State could present a direct threat to the Arab monarchies at a time of growing social discontent…In our view, Saudi and other regional rulers may prefer to re-engage the US to help protect established borders from the expanding caliphate. What could Arab countries offer the West to help contain this threat? Lower oil prices.”
This issue is too complex to make a prediction on. Nevertheless it will have a huge impact on the direction in which oil prices will go in the years to come. Further, the chances of the current turmoil in the Middle East escalating, still remain. As Milton Ezrati writes in a piece titled
ISIS, Oil, and the Economy on Huffington Post “There is no mistaking the huge remaining importance of Persian Gulf supplies. If the turmoil there were to take a significant portion of this output off line suddenly, the world would be hard pressed to replace it, and prices would rise with all their ill effects.”
He further points out that “the Persian Gulf itself is also a choke point of no small significance in oil transport. The EIA reports that upwards of 35 percent of sea going oil and gas passes through the Gulf and the narrow Strait of Hormuz at its head. If Iran were to become further embroiled in Iraq’s problems or otherwise come to a confrontation with Western powers, the strait would close and the world would find itself without any of this still crucial supply.”
The price of oil is not just determined by the demand and supply equation. The politics of the Middle East and which side of the bed Uncle Sam wakes up from remain very important factors. For any analyst trying to predict the price of oil, taking all these “qualitative” factors into account remains very difficult.
To conclude, what are the lessons that we can draw from this. First and foremost we need to ensure that the price of diesel is decontrolled. And more than that we need to ensure that it continues to be decontrolled in the years to come, even if the global price of oil rises.

The article originally appeared on www.FirstBiz.com on Oct 18, 2014

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

Death by oil: Why US and Saudi Arabia are colluding to drive down the price of oil

oil

Vivek Kaul

Oil prices have been coming down since the middle of this year. There are several reasons for the same, as I explained in a piece yesterday. One reason being suggested is that it is in the interest of both the United States as well as Saudi Arabia that oil prices go lower than they currently are. Further, these countries might even be colluding to ensure that oil prices are driven lower.
Before we get into the details, it is important to discuss some history here. At the end of the Second World War, the American President Franklin
Roosevelt realised that a regular supply of oil was very important for the well being of America and the evolving American way of life. He travelled quietly to USS Quincy, a ship anchored in the Red Sea. Here he was met by King Ibn Sa’ud of Saudi Arabia, which was by then home to the biggest oil reserves in the world.
The United States’ obsession with the automobile had led to a swift decline in domestic reserves, even though America was the biggest producer of oil in the world at that point of time. The country needed to secure another source of assured supply of oil. Hence, in return for access to oil reserves of Saudi Arabia, King Ibn Sa’ud was promised full American military support to the ruling clan of Sa’ud.

Over the years, Saudi Arabia has also ensured that Organization of Petroleum Exporting (OPEC) continues to price oil in US dollars. This has been a major reason behind the American dollar continuing to be the international reserve currency. Given this, the United States and Saudi Arabia have always had a close relationship which has proven beneficial to both the countries.
The recent past has seen the rise of the Islamic State of Iraq and Syria (ISIS) which is trying to redraw political boundaries in the Middle East. As analysts of Bank of America-Merrill Lynch points out in a report titled
Does Saudi want $85 oil? “Recent advances by the Islamic State in Syria and Iraq have disrupted Middle East politics. The Islamic State aspires to bring any areas where Muslims live under its control…[It] rejects political divisions established by Western powers at the end of World War I.”
This scenario has led to a situation where Saudi Arabia is cooperating with the United States to keep oil prices down. Typically, oil prices start to rise at the sign of the slightest trouble in the Middle East. Nevertheless, that hasn’t happened this time around. The major reason for the same is that the ruling clan of the Sa’uds wants the United States to keep the security guarantee that Roosevelt gave them, going. In fact, in September before addressing the United States on the threat of ISIS, President Barack Obama is supposed to have called up
Saudi Arabia’s King Abdullah Bin Abdulaziz Al Saud.
The ISIS has captured oilfields in Syria and Iraq. This oil
is sold at a discount to the world price of oil, to Turkey, which in turn, resells it in Europe. It is estimated that ISIS earns around $3 million from oil sales. By driving down price this earning can be driven down as well. Hence, United States and Saudi Arabia can ensure that they are able to cut down the funding of ISIS.
And how is this being done? Typically, whenever oil prices start to fall, Saudi Arabia starts to cut down on production, so that oil supply comes down, and this immediately slows down the fall in price. But that doesn’t seem to have happened this time around. As the Bank of America-Merrill Lynch analysts point out “We have yet to see a Saudi output cut in response the lower prices. Oil has fallen $15/bbl[barrel] from a peak of $115/bbl in mid-June, but Saudi production has not bulged.”
This has helped keep oil prices down. The threat is that ISIS might want to go beyond Syria and Iraq in the days to come. “It should perhaps not come as a surprise that the threat of a stateless group that challenges the status quo by attempting to redraw national borders is shifting incentives for key regional and global players…The Islamic State could present a direct threat to the Arab monarchies at a time of growing social discontent…In our view, Saudi and other regional rulers may prefer to reengage the US to help protect established borders from the expanding caliphate. What could Arab countries offer the West to help contain this threat? Lower oil prices,” the Bank of America-Merrill Lynch analysts point out.
An interesting comparison to this situation is the time when Iraq attacked Kuwait more than twenty years back. As Thomas Piketty writes in
Capital in the Twenty-First Century: “If the United States, backed by other Western powers had not driven the Iraqi Army out of Kuwait in 1991, Iraq would probably have threatened Saudi Arabia’s oil fields next, and it is possible that other countries in the region, such as Iran, would have joined the fray to redistribute the region’s petroleum rents.”
This explains very well, why Saudi Arabia needs the security guarantee from the United States, and in return it is offering a lower price of oil. A lower oil price also helps the United States and other western powers neutralize Russia, which in 2013 was the biggest producer of oil in the world, having produced 13.28% of the oil being produced globally.
There are other political factors at work as well. The Kurds have been demanding autonomy from Iraq and are being allowed to sell oil at a lower price. As Vijay Bhambwani, CEO of BSPLIndia.com explains “
The Kurds have started selling high quality arab light grade sweet crude at US$ 55 / barrel. Initial despatches were to Israel. Since the Kurds have a militia of 55,000 strong fighters (Peshmerga) which is funded by oil sales, the western countries are allowing the Kurds to sell their oil below market prices in return for fighting the ISIS forces.”
Over and above this, there is the case of Iraqi cleric Muqtada Al-Sadr, son of the slain chief cleric of Iraq under Saddam Hussein’s rule. As Bhambwani explains “Al-Sadr is the founder / commander of the Mehdi army which is dominated by
Shias and is pro Iran. If he seizes power, he is likely to re-negotiate oil contracts with the west, keeping the Saudis on tenterhooks. Saudis are therefore open to hiking output and cutting prices.”
In fact, by cutting the price of oil, the Saudis also hope to neutralize the shale oil boom in the United States and Canada. This boom has led to the U
nited 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.
But shale oil is expensive to produce and it is financially viable only if oil price remain at a certain level. As Bank of America-Merrill Lynch analysts point out “
With production costs ranging from $50 to $75/bbl at the well head, a decline in Brent crude oil prices to $85 would likely be a major blow to US shale oil players and lead to a significant slowdown in investment.”
In the end, there is enough evidence to conclude that Saudi Arabia has been working towards pushing down the price of oil, in order to ensure that the United States security guarantee continues.
The article originally appeared on www.FirstBiz.com on Oct 8, 2014

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