Oil

Oil at $65: Where oil prices go will depend on who blinks first, shale oil producers or OPEC

oil

Vivek Kaul

The West Texas Intermediary (WTI) crude oil price has touched a five year low of $65 per barrel. As I write this, the WTI price stands at $64.5 per barrel. WTI is one of the grades of crude oil and is used as a benchmark to set oil prices.
This fall in oil prices has come about after the Organisation of the Petroleum Exporting Countries(OPEC) in a meeting on November 27, 2014, decided not to cut their production. In the past whenever oil prices fell, OPEC used to cut production in order to ensure that prices did not continue to fall. This has not happened this time around.
The primary reason for the same has been the rise of the shale oil producers in the United States. The United States was producing around 4 million barrels of oil per day in mid 2008. Since then the production has jumped to 8.97 million barrels per day (as of end of October 31, 2014). The entire incremental production has come from shale oil.
This has meant that the United States which is the biggest consumer of oil in the world is importing far lesser oil than it was in the past. Amrborse-Evans Pritchard writing in The Telegraph points out that “America has cut its net oil imports by 8.7m barrels per day since 2006, equal to the combined oil exports of Saudi Arabia and Nigeria.” This is a reason to worry for OPEC and it has decided to not cut production significantly, and in the process it hopes to make shale oil producers unviable.
Prtichard also quotes Chris Skrebowski, former editor of Petroleum Review, as saying that Saudi Arabia wants to cut down the annual increase in the production of US shale oil from the current one million barrels per day to 500,000 barrels per day. Saudi Arabia is the leader of the OPEC cartel and OPEC largely does what Saudi Arabia wants it to.
Given this it is not surprising that OPEC has continued to maintain a production of over 30 million barrels per day, despite falling oil prices. As Javed Mian writes in an investment letter titled Stray Reflections and dated November 2014: “It is not surprising to see OPEC production – relative to its 30 million barrels a day quota – rising from virtual compliance to one where the cartel is producing above its agreed production allocation. Output rose to 30.974 million barrels per day in October, a 14-month high led by gains in Iraq, Saudi Arabia and Libya.”
The production of OPEC in the month of November 2014 stood at 30.56 million barrels per day. This was lower than the production in October, but still higher than the target of 30 million barrels per day.
OPEC is working with the assumption that shale oil is expensive to produce Nevertheless as I pointed out in an earlier piece on shale oil there are as many estimates on the production cost of shale oil going around, as there are analysts.
In a September 2014 report Bank of America-Merrill Lynch had put the production costs of shale oil from $50-75 per barrel. Mian whose newsletter I have quoted earlier put the break-even price at $57 per barrel. Analysts at Citibank recently said that the price of oil would have to fall below $50 a barrel for completely halting shale oil production in the United States.
Evans-Pritchard goes even lower. As he writes: “The International Energy Agency said most of North Dakota’s vast Bakken field “remains profitable at or below $42 per barrel. The break-even price in McKenzie County, the most productive county in the state, is only $28 per barrel.” He quotes Edward Morse, Citigroup’s commodities chief as saying that the  “full cycle” cost for shale production is $70 to $80, but this includes the original land grab and infrastructure. Nevertheless, the remaining capital expenditure “to bring on an additional well, could be as low as the high-$30s range.”
A Bloomberg report points out “Only about 4% of US shale output needs $80 a barrel or more to be profitable, according to the International Energy Agency. Most production in the Bakken formation, one of the main drivers of shale oil output, remains commercially viable at or below $42, the Paris-based agency estimates.”
What these data points tell us is that the Saudi led OPEC will have to drive down oil prices further, in order to ensure that production of shale oil becomes unviable. At least that is the observation one can make from all the data that is available.
The question is till when OPEC keep driving down prices. Mian estimates that “the current oil decline has potentially cost OPEC $250 billion of its recent earnings of $1 trillion”. Further, “lower the price of oil falls, the greater the need to compensate for lower revenues with higher production, which paradoxically pushes oil prices even lower,” Mian writes.
Most OPEC countries have built their budgets around high oil prices. “Once all the costs of subsidies and social programs are factored-in, most OPEC countries require oil above $100 to balance their budgets. This raises longer-run issues on the sustainability of the fiscal stance in a low-oil price environment,” writes Mian.
Hence, the oil price at which the budgets of OPEC countries and other oil exporting countries breaks even, is very high. “The fiscal break-even cost is $161 for Venezuela, $160 for Yemen, $132 for Algeria, $131 for Iran, $126 for Nigeria, and $125 for Bahrain, $111 for Iraq, and $105 for Russia, and even $98 for Saudi Arabia itself, according to Citigroup,”writes Evans-Pritchard.
Given this, while the OPEC is trying to make shale oil unviable it is bleeding as well.
Nevertheless, Saudi Arabia seems to have decided that it wants to drive down the price of oil and that is what is important. The Kingdom has the ability to withstand lower oil prices for a few years, feels Mian. As he writes “Saudi Arabia appears to be comfortable with much lower oil prices for an extended period of time. The House of Saud is equipped with sufficient government assets to easily withstand three years at the current oil price by dipping into their $750 billion of net foreign assets.”
The question is who will blink first, the Saudi Arabia led OPEC or the shale oil companies. And that will decide how far the oil price will fall.

The article originally appeared on www.FirstBiz.com on Dec 2, 2014

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

Saudi emerges king at OPEC meet: Oil prices will remain low for now

oilVivek Kaul

The oil ministers of the Organization of Petroleum Exporting (OPEC) countries met in Vienna yesterday. They decided to keep the total production of oil coming from OPEC at 30 million barrels per day. This is one million barrels per day more than OPEC’s estimate of the demand for its oil in 2015.
“It was a great decision,” said Saudi Oil Minister Ali al-Naimi, after talks which lasted for around five hours. With this decision not to cut production the price of oil fell further, and as I write this the price of Brent crude oil stands at $72.2 per barrel of oil.
The decision not to cut production went against the demand of OPEC members like Iran and Venezuela, who had demanded that production be cut. A falling oil price is hurting these countries badly given that money earned from selling oil is a major source of revenue for the respective governments.
Also, in the past, OPEC has been quick to cut production whenever prices have fallen and that has ensured that prices don’t fall any further. But that doesn’t seem to be happening this time around. Saudi Arabia, the largest producer of oil within OPEC, wants to drive down the price of oil.
The question that crops up here is why did OPEC go with what Saudi Arabia wanted it to? It has 11 other countries as members as well. While OPEC has been regularly referred to as a cartel, it is important to understand that the structure of OPEC is different from that of a cartel. It is probably better to define the structure of OPEC as what economists call a “leading firm” model of oligopoly, a market which is dominated by a small number of sellers and in which the largest producer sets the price and the others follow.
Saudi Arabia is the largest producer within OPEC. Within OPEC, it also has the almost unquestioned support of what are known as the sheikhdom states of Bahrain, Kuwait, the United Arab Emirates, and Qatar.
These countries have faced threats from other OPEC members, like Iraq and Iran, in the past. For many years, Iraq had been eyeing Kuwait. It had tried to annex Kuwait in 1961 (and it tried again in the early 1990s). The support of Saudi Arabia, the largest nation in the region, is very important for these countries. Hence, these countries tend to go with Saudi Arabia, not leaving much space for the other member countries to disagree.
Moral of the story: OPEC does what Saudi Arabia wants it to do. And these days Saudi Arabia seems to want lower oil prices. Why is that the case? Look at the table that follows. The table shows the daily oil production in the United States, which had fallen to around 4 million barrels per day in 2008. It has since jumped up again to around 9 million barrels per day, the kind of level not since the mid 1980s.
This has happened primarily because of a boom in shale oil production in the United States. As Javed Mian writes in Stray Reflections newsletter for the month of November “The US pumped 8.97 million barrels a day by the end of October (the highest since 1985) thanks partly to increases in shale-oil output which accounts for 5 million barrels per day.”
The more shale oil United States produces the lesser it has to depend on OPEC and other parts of the world, to fulfil its massive oil requirements. The trouble is that shale oil is expensive to produce and is viable only if oil continues to sell at a certain price. Given this, Saudi Arabia wants to ensure that price of oil is driven down further, so that it can drive the shale oil producers out of business.
There are various estimates about the oil price at which it is viable to produce shale oil. A report brought out by Deutsche Bank said that around 40% of shale oil production in the United States next year, would be unviable if the price of oil fell below $80 per barrel. Very recently, this was a sentiment echoed by the chief economist of the International Energy Agency as well.
Nonetheless, Maria van der Hoeven, executive director of the International Energy Agency, contradicted her chief economist by telling Reuters recently that 82 percent of the American shale oil firms had a break-even price of $60 or lower.
There are still other estimates. As Mian writes in his newsletter “The median North American shale development needs an oil price of $57 to breakeven today, compared to $70 last year according to research firm IHS.”
Analysts at Citibank recently said that the price of oil would have to fall below $50 a barrel for completely halting shale oil production in the United States. Also, many shale oil companies would continue to remain viable for an oil price of anywhere between $40 to $60 a barrel. It would be safe to say that there are as many break-even prices for shale oil as there are analysts. And it is very difficult to figure out which of these estimates is correct.
This is not the first time Saudi Arabia is following the strategy of bleeding out its competitors. It did the same nearly three decades back. “This has happened once before. By the mid-1980’s, as oil output from Alaska’s North Slope and the North Sea came on line (combined production of around 5-6 million barrels a day), OPEC set off a price war to compete for market share. As a result, the price of oil sank from around $40 to just under $10 a barrel by 1986,” writes Mian.
Hence, Saudis are putting to work a strategy that they have used in the past. Nevertheless, it doesn’t seem to have had the necessary impact on the production of oil by shale oil firms in the United States. On November 10, earlier this month, the US Energy Information Administration said that the seven largest shale oil players would be producing 125,000 barrels per day more in December than they had in November.
One reason for this is that the money that has already gone into producing shale oil is essentially a sunk cost. Hence, production is not going to be stopped immediately. As Ben Hunt who writes the Epsilon Theory newsletter puts it “There’s just too much non-cartelized money, technology, and political capital invested in US shale production to slow it down.”
Also, companies already have long term production contracts in place. These contracts require that they deliver a minimum level of production, even if it means selling at a loss. “Failure to comply could mean the loss of the lease and any future upside when prices [are] normalized,” writes Chip Register on Forbes.com.
Legendary oil man, T Boone Pickens feels that Saudi Arabia has entered into a stand-off to “see how the shale boys are going to stand up to a cheaper price.”
To conclude, Saudi Arabia driving down the price of oil hasn’t yet had an impact on shale oil production. Given this, it is likely that Saudi Arabia led OPEC will continue to drive down the oil price in the months to come. “In the current cycle, though, prices will have to decline much further from current levels to curb new investment and discourage US production of shale oil,” writes Mian.
It is also possible that the United States government may decide to intervene and introduce “tariffs on cheap foreign oil imports,” to keep the local shale oil industry viable.
The United States government will also have to take into account the fact that Saudi Arabia buys and sells oil in dollars. This ensures that in order to earn these dollars countries carry out international trade in dollars and accumulate a major part of their foreign exchange in dollars. This ensures that dollar continues to have an “exorbitant privilege” allowing United States to repay its debt to foreigners by simply printing them.
Further, it also helps keep the interest rates in the United States low, as countries line up to invest their foreign exchange reserves in treasury bonds issued by the United States government. Given this, its a Catch 22 situation for the United States. Does it encourage its local shale oil industry and reduce its dependence on importing oil from the Middle East? Or does it work against the “exorbitant privilege” of the dollar? Its not an easy choice to make.
Hence, its safe to predict that oil prices will continue to be low in the short-term. There are too many interplaying factors at work making it impossible to predict how things will turn out to be in the long run.
All I can say is, stay tuned.

The column originally appeared on www.FirstBiz.com on Nov 28, 2014

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

Oil prices at a 4-year low: Decoding why Saudi Arabia won’t mind low prices for some time

oil

Vivek Kaul 

Oil prices have fallen to a four year low. As I write this the price of Brent crude oil stands at $82.82 per barrel, down 30% from June 2014.
The latest drop in price has come after Saudi Arabia, the biggest producer of oil within the Organisation of Petroleum Exporting Countries(OPEC), the global oil cartel, decided to cut the price at which it sold oil to the United States by roughly 45 cents to a barrel. At the same time it increased the price to customers in Europe and Asia, for the first time in five months.
The theory going around for sometime has been that Saudi Arabia needs the price of oil to be at least at $83-84 per barrel to balance its budget. Hence, it won’t allow the price of oil to fall below that level. But that as we have seen hasn’t turned out to be the case with the price of Brent crude now less than $83 per barrel.
So, the question is why is Saudi Arabia allowing the price of oil to fall and taking a hit on its income? On many past occasions, the country has cut production when the price of oil is falling. This has helped the country prevent a fall in the price of oil.
As analysts at Merrill Lynch write in a recent report titled Does Saudi Want $85 oil “Our analysis suggests that since 2008, on average, a 10% drop in oil prices has historically led to a 1.5% reduction in Saudi production 3 months later, rising to 2% after 6 months.” Nevertheless, it doesn’t seem to be doing that this time around.
So what has changed? In 2013, United States became the largest producer of oil in the world, displacing Saudi Arabia. The shale oil fields of the United States are producing a lot of oil, and this has helped the country to become the largest producer of oil in the world. This has led to American imports of oil from Saudi Arabia coming down. Data from the US Energy Information Administration tells us that the imports from Saudi Arabia comprised of around 4.6% of total US oil consumption in August 2014. This is down from 7% in August 2013.
In fact, over the last two months, American imports of oil from Saudi Arabia have fallen under one million barrels per day, against 1.4 million barrels earlier. If one looks at the data over a longer period the situation looks even more grim. Over a period of last six years, the production of oil in the United States has increased by 70%. This has led to the reduction of oil imports from OPEC by half. Saudi Arabia is the biggest producer of oil within OPEC.
Saudi Arabia is trying to set this situation right. Shale oil is expensive to produce. Given this, it is viable for companies to produce oil, only if the price of oil remains at a certain level. As the 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.”
Hence, Saudi Arabia is trying to make the production of shale oil unviable for companies which produce shale oil, by driving down the price of oil. The question is how long can the Saudis keep driving the price of oil?
Loren Steffy writing for Forbes.com points out that “The Saudis appear willing to use the abundance of U.S. production to allow prices to keep sliding, enabling the kingdom, which can profit from oil at as little as $30 a barrel, to grab a larger share of the global market.”
While the cost of production of oil in Saudi Arabia maybe low, there are other costs that need to be taken into account. David Strahan in his book The Last Oil Shock explains that that over the years in Saudi Arabia is that as oil prices have gone up, the rulers have been able to run one of the most lavish welfare systems in the world. This has helped them buy political legitimacy and the support of its citizens. For a very long time, the citizens of Saudi Arabia paid no tax, yet had access to free healthcare and education. At the same time, housing, electricity, food and fuel were subsidized. All this was possible because of all the money that was being earned by selling oil. And that is why for Saudi Arabia to balance its budget (i.e. the expenditure of the government is equal to its income), it needs to sell oil at a price of $83-84 per barrel.
Given this, will the Saudis start cutting production and pushing the price of oil up? “Much has been written recently about the marginal costs of production of crude oil, and how much which nation will “hurt” if West Texas Intermediate oil prices fell below the US$ 80 mark,” says Vijay L Bhambwani, CEO of BSPLIndia.com. West Texas Intermediate is the American oil benchmark and is currently at $77.2 per barrel.
Nevertheless, as long as long as Ghawar, Safania, Shayba, Abqaiq, Berri, Manifa, Abu Safah, Faroozan oil fields are viable, Saudis can sustain even lower prices, feels Bhambwani. At the same time, the fact that Aramco (officially known as Saudi Arabian Oil Company) has deep pockets is a point worth remembering. “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,” adds Bhambwani.
Also, it is worth remembering that the Saudi central bank has reserves worth $734.7 billion. Further, as Edward Chow a senior fellow at the Center for Strategic & International Studies in Washington, recently told Bloomberg “The Saudis ran deficits from the mid-1980s until the late 1990s and may be prepared to do so again.”
What this tells us is that the Saudis can easily sustain low oil prices in the short-term, if they are looking to break the backs of the shale oil companies. At the same time low oil prices will hurt Iran, much to the delight of the Saudins.
To conclude, any fall in price of oil, will benefit India, and help the government further control its fiscal deficit. Fiscal deficit is the difference between what a government earns and what it spends. So, India should hope that Saudi Arabia continues with its current strategy of driving down the price of oil.

The column appeared on www.FirstBiz.com on Nov 6, 2014

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

Deregulating diesel prices: A good decision that will be tested when oil prices rise again

light-diesel-oil-250x250

Vivek Kaul

The government on Saturday announced the decision to deregulate diesel prices. “Henceforth—like petrol—the price of diesel will be linked to the market,” the finance minister Arun Jaitley said after a cabinet meeting. “Whatever the cost involved, that is what consumer will have to pay,” he added.
After this decision the price of diesel was reduced by around Rs 3.50 per litre (the cut would vary all around India given the different rates of taxes in different states). This was the first cut in the price of diesel since January 2009.
The proposal to allow oil marketing companies to decide the price of diesel was first made in 1997, when Inder Kumar Gujral was the prime minister. The price of petrol and diesel were finally deregulated in April 2002, under the regime of Atal Bihari Vajpayee.
But this decision was over turned in late 2004, around the time oil prices had touched $50 per barrel. In November 2004, Mani Shankar Aiyar, the then Petroleum Minister said “since January 1, 2004, government was dictating even petrol and diesel prices… We have been far more honest in saying the government will control prices of cooking and auto fuels.”
This led to the oil marketing companies having to sell oil products at a price at which they incurred under-recoveries. The government compensated a part of these under-recoveries. And due to this the government expenditure and in turn, the fiscal deficit went up. Fiscal deficit is the difference between what a government earns and what it spends.
In the last two financial years (i.e. 2012-2013 and 2013-2014) the total petroleum subsidy (subsidy for diesel, cooking gas and kerosene) amounted to Rs 1,82,359.9 crore. As an article in The Wall Street Journal points out “Around half of that was for diesel. Before diesel prices were freed, economists estimated that a $1 per barrel rise in the global price of oil would increase India’s subsidy bill by around $1 billion a year.”
As government expenditure in order to pay for the under-recoveries of the oil marketing companies went up over the years, so did its borrowing. When the government borrows more, it crowds out the other borrowers i.e. it leaves lesser on the table for the private borrowers to borrow. This, in turn, pushes up interest rates, as the other borrowers now need to compete harder.
The high interest rate scenario that has prevailed in India over the last five-six years has been because of this increased government borrowing. If diesel prices had continued to be deregulated this wouldn’t have happened.
Other than the high interest rates, there were several other things that happened. But before we get into that let’s see what the economist Henry Hazlitt writes in Economics in One Lesson “We cannot hold the price of any commodity below its market level without in time bringing about two consequences. The first is to increase the demand for that commodity. Because the commodity is cheaper, people are tempted to buy, and can afford to buy, more of it…In addition to this production of that commodity is discouraged. Profit margins are reduced or wiped out. The marginal producers are driven out of business.”
The demand for diesel went up in the form of people buying more and more passenger cars that ran on diesel, given the substantial difference between the price of petrol and diesel. This led to the government of India indirectly subsidising car owners over the last few years. Hence, rich consumers ended up consuming more than their fair share of diesel.
As Hazlitt writes in this context: “Unless a subsidized commodity is completely rationed, it is those with the most purchasing power than can buy most of it. This means that they are being subsidized more than those with less purchasing power…What is forgotten is that subsidies are paid for by someone, and that no method has been discovered by which the community gets something for nothing.”
The move to dismantle diesel price deregulation also drove private marketers of oil (Reliance, Essar etc) out of business, as suggested by what Hazlitt had to say on the issue. The government owned oil marketing companies (Indian Oil, Bharat Petroleum, Hindustan Petroleum) were compensated by the government and the upstream oil companies (like ONGC, Oil India Ltd) for selling diesel at a lower price. There was no such compensation for the private oil marketers and hence, they had to shut down their business.
Once all these factors are taken into account the decision to deregulate diesel prices is a brilliant one even though it took a long time to come. Nevertheless, it will not lead to any major immediate benefits for the government. Since Narendra Modi took over as the prime minister of the country, the oil price has fallen dramatically.
As per the Petroleum Planning and Analysis Cell, the international crude oil price of Indian Basket as on October 17, 2014, stood at $ 85.06 per barrel. This price had stood at $108.05 per barrel on May 26, 2014, the day Modi took over as the prime minister.
Interestingly, during April to June 2014, the first quarter of this financial year, the under-recoveries of oil marketing companies on the sale of diesel, cooking gas and kerosene were at Rs 9,037 crore. This is much lower in comparison to the huge under-recoveries that these companies suffered over the last few years.
Also, since January 2013, the price of diesel has been raised by 50 paisa every month. This has led to the under-recoveries of oil marketing companies coming down significantly. Interestingly, for the fortnight starting October 16, 2014, the over-recovery on diesel stood at Rs 3.56 per litre. And that explains why the government was able to cut the price of diesel by around Rs 3.50 per litre.
What this tells us clearly is that there will be no immediate benefit on the fiscal front of diesel price deregulation to the government. Further, the real benefit of this reform will kick in only once oil prices start to rise. And it is at that point of time, the government of the day will have to resist any temptation to start controlling diesel prices, as has been the case in the past.
If it resists this temptation, the upstream oil companies (ONGC, Oil India) will also benefit because the government will not strip them of their profits to pay off the under-recoveries of the oil marketing companies. This explains why the share price of ONGC is up by more than 5% today.
Nevertheless, one immediate benefit of the diesel price cut will be a slightly lower inflation. On the flip side, this also means that if and when oil prices start to go up, the inflation will start reflecting a higher price of diesel more quickly than was the case in the past.
Another benefit of the deregulation will be that private marketers can now look to get back into the business. This is good news for the Indian consumer as it will mean more competition, which may lead to better services. In fact, one huge problem with the products sold by the public sector oil marketing companies is adulteration. Given the cheap price of kerosene, there is lot of adulteration of petrol and diesel. Private marketers can make in roads into the market by providing pure petrol and diesel, and hope to attract the attention of the consumer.
To conclude, there are a few immediate benefits of diesel price deregulation, but the real challenge and the benefit for the government will only come, once oil prices start to go up again.

The article originally appeared on www.FirstBiz.com on Oct 20, 2014

(Vivek Kaul is a writer. He tweets @kaul_vivek) 

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)