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Shale vs crude: Why oil prices are on a free fall even as Opec members suffer

oil
The latest price of the Indian basket for crude oil was at $35.72 per barrel. It has fallen by 16% over the last one month and by 33% since end December 2014.
Yesterday, the Brent crude oil was selling at $37-38 per barrel. Lower quality oil is selling at even below $30 per barrel. As Amrbose Evans-Prtichard writes in The Telegraph: “Basra heavy crude from Iraq is quoted at $26 in Asia, and poor grades from Western Canada fetch as little as $22. Iran’s high-sulphur Foroozan is selling at $31.”

What has led such low levels of oil price? Over the last one year, the Organization of the Petroleum Exporting Countries(OPEC), an oil cartel of some of the biggest oil producing countries in the world, has been flooding the market with oil in order to make the shale oil being pumped in the United States, unviable. Pumping shale oil is an expensive process and is not viable at lower oil price levels.

In fact, the oil ministers of the OPEC countries met in early December and they pretty much decided to continue doing things the way they have been up until now, over the last one year. In the past, any likely slowdown in oil prices was met with oil production cuts within the OPEC. That hasn’t happened over the last one year and isn’t happening now either.

As the International Energy Agency(IEA) points out in its monthly oil report for December 2015: “OPEC’s decision to scrap its official production ceiling and keep the taps open is a de facto acknowledgment of current oil market reality. The exporter group has effectively been pumping at will since Saudi Arabia convinced fellow members a year ago to refrain from supply cuts and defend market share against a relentless rise in non-OPEC supply.”

The rise in the supply of non-OPEC oil has primarily happened on account shale oil being pumped in the United States and to some extent in Canada, over the last few years. In order to make companies pumping shale oil unviable, OPEC has been relentlessly pumping oil. As the IEA monthly report points out: “OPEC supply since June has been running at an average 31.7 million barrels per day, with Saudi Arabia and Iraq – the group’s largest producers – pumping at or near record rates. Riyadh has held supply above 10 million barrels per day since March to satisfy demand at home and abroad while Iraq, including the Kurdistan Regional Government (KRG), is doing its level best to keep production above the 4 million barrels per day mark first breached in June.”

Also, as oil prices have fallen, OPEC and non-OPEC oil producing countries have had to pump more and more oil, in order to ensure that their governments have some money going around to spend. As the Russian finance Anton Siluanov told Ambrose. “There is no defined policy by the OPEC countries: it is everyone for himself, all trying to recapture markets, and it leads to the dumping that is going on.”

Further, sanctions against Iran are likely to be lifted early next year and more oil will then hit the international oil market. The Financial Times quotes an oil trader as saying: “It seems the Iranians are fulfilling the requirements for the lifting of sanctions faster than expected.” said one London-based oil trader.

The IEA monthly report expects the extra oil from Iran to add 300 million barrels to the already swelling oil inventories. In fact, the November 2015 oil report of the IEA had put the total global stockpiles of oil at 3 billion barrels.

So how long will this last? Given the number of factors that impact the price of oil, predicting which way it will head, has always been tricky business.  As Philip Tetlock and Dan Gardner write in Superforecasting—The Art and Science of Prediction: “Take the price of oil, long a graveyard topic for forecasting reputations. The number of factors that can drive the price up or down is huge—from frackers in the United States to jihadists in Libya to battery designers in Silicon Valley—and the number of factors that can influence those factors is even bigger.”

Nevertheless, it seems that one year down the line the Saudi strategy of driving down the price of oil, in order to drive down non-OPEC oil production seems to be working. As the IEA oil report points out: “There is evidence the Saudi-led strategy is starting to work. Lower prices are clearly taking a toll on non-OPEC supply, with annual growth shrinking below 0.3 million barrels per day in November from 2.2 million barrels per day at the start of the year. A 0.6 million barrels per day decline is expected in 2016, as US light tight oil – the driver of non-OPEC growth – shifts into contraction.”

Also, it is worth pointing out here that oil exporting countries are having a tough time balancing their budgets. The fiscal deficit of Saudi Arabia has touched 20% of its gross domestic product (GDP). Fiscal deficit is the difference between what a government spends and what it earns. As Evans-Pritchard puts it: “Opec revenues have collapsed from $1.2 trillion a year in 2012 to nearer $400 billion next year.”

Hence, it is safe to say that the OPEC strategy of driving down the price of oil is hurting the member countries. Given this, the price of oil cannot be at such low levels for much long. But at least in the short run, the oil price will continue to stay low.

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

The column originally appeared on Firstpost on December 15, 2015

If we go by what Keynes said, the world is currently going through a depression

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In a few weeks, it will be the seventh anniversary of the start of the current financial crisis. The fourth largest investment bank on Wall Street, Lehman Brothers, filed for bankruptcy on September 15, 2008. A day later, AIG, the largest insurance company in the world, was nationalized by the United States government.

A week earlier two governments sponsored enterprises Fannie Mae and Freddie Mac had also been nationalized by the United States government. In the months to come many financial institutions across the United States and Europe were saved and resurrected by governments all across the developed world. Some of them were nationalized as well.

Economic growth crashed in the aftermath of the financial crisis. Central banks and governments reacted to this by unleashing a huge easy money programme, where a humongous amount of money was printed(or rather created digitally) in order to drive down interest rates, in the hope that people would borrow and spend, companies would borrow and spend, and economic growth would return again.

And how are we placed seven years later? It would be safe to say that despite all that governments and central banks have done in the last seven years, the world hasn’t returned to its pre-crisis level of economic growth.

In fact, if we go by what the greatest economist of the twentieth century, John Maynard Keynes, wrote in his tour de force, The General Theory of Employment, Interest and Money, a large part of the developed world is currently going through a “depression”.

Keynes, defined a depression as “a chronic condition of sub-normal activity for a considerable period without any marked tendency towards recovery or towards complete collapse.”

This is something that the economists tend to ignore. As James Rickards writes in The Big Drop—How to Grow Your Wealth During the Coming Collapse: “Mainstream economists and TV talking heads never refer to a depression. Economists don’t like the word depression because it does not have an exact mathematical definition. For economists, anything that cannot be quantified does not exist.”

Hence, if we go as per what Keynes said, depression is a scenario where economic growth is below the long-term trend growth. And that is precisely how large parts of the global world have evolved in the aftermath of the financial crisis. As Rickards writes: “The long-term growth trend for U.S. GDP is about 3%.

Higher growth is possible for short periods of time. It could be caused by new technology that improves worker productivity. Or, it could be due to new entrants into the workforce…Growth in the United States from 2007 through 2013 averaged 1% per year. Growth in the first half of 2014 was worse, averaging just 0.95%.”

The current year hasn’t been any better either. The economic growth between January and March 2015 stood at 0.6%. Between April and June 2015, it was a little better at 2.3%.  As Rickards puts it: “That is the meaning of depression. It is not negative growth, but it is below-trend growth. The past seven-years of 1% growth when the historical growth is 3% is a depression as Keynes defined it.”

The United States economy accounts for nearly one-fourth of the global economy and if it grows slowly that has an impact on many other economies as well.
China, another big economy, has also been growing below its long term growth rate. Between 2003 and 2007, the Chinese economy grew by greater than 10% in each of the years. It slowed down in 2008 and 2009 as the financial crisis hit, and grew by only 9.6% and 9.2% respectively. In 2010, the economic growth crossed 10% again with the economy growing by 10.6%. This was after the Chinese government forced the banks to unleash a huge lending programme.

Nevertheless, growth fell below 10% again and since then the Chinese economy has been growing at below 10%. In fact, in the recent past, the economy has grown at only 7%, which is very low compared to its rapid rate of growths in the past.

Interestingly, people who observe China closely, are sceptical of even this 7% rate of economic growth. As Ruchir Sharma, Head of Global Macro and Emerging Markets at Morgan Stanley wrote in a recent column for the Wall Street Journal: “Chinese policy makers seem unwilling to accept that downturns are perfectly normal even for economic superpowers…But Beijing has little tolerance for business cycles and is now reviving efforts to stimulate sectors that it had otherwise wanted to see fade in importance, from property to infrastructure to exports….While China reported that its GDP grew exactly in line with its growth target of 7% in the first and second quarters this year, all other independent data, from electricity production to car sales, indicate the economy is growing closer to 5%.”

The moral of the story being that China is growing much slower than it was in the past. What this means is that countries like Brazil and Australia, which are close trading partners of China, will also feel the heat. Over and above this, much of Europe continues to remain in a mess. As Rickards puts it: “Keynes did not refer to declining GDP; he talked about “sub-normal” activity. In other words, it is entirely possible to have growth in a depression. The problem is that the growth is below trend. It is weak growth that does not do the job of providing enough jobs or staying ahead of national debt.”

In fact, much of the economic growth that has been achieved through large parts of the developed world has been on the basis of more lending carried out at very low interest rates. Data from the latest annual report of the Bank of International Settlements based out of Basel in Switzerland, suggests, that the total global debt has touched around 260% of the global gross domestic product (GDP). In 2008, it was around 230% of the global GDP.

As the BIS annual report for the financial year ending March 31, 2015 points out: “very low interest rates that have prevailed for so long may not be “equilibrium” ones, which would be conducive to sustainable and balanced global expansion. Rather than just reflecting the current weakness, low rates may in part have contributed to it by fuelling costly financial booms and busts. The result is too much debt, too little growth and excessively low interest rates.”

The tragedy is that there seems to have been no change in the thought process of those who are in decision making positions.

The column originally appeared on Firstpost on Aug 20, 2015

(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)

Eight things you need to know about falling oil prices

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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.
The 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)

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)