Lower oil prices – and what they indicate
The sudden slump in oil prices, which have fallen over 28% in the past four months and are now at their lowest point in 4 years, has sent tremors through the capitals of the world’s great oil powers and will undoubtedly have knock on effects for the world economy. In the article below we explore the importance of fuel pricing, its relationship with the world economy and the implications of a sub $80 per barrel price.
What determines oil prices?
In the early days, finding oil during a drill was considered somewhat of a nuisance as the intended treasures were normally water or salt. It wasn’t until 1857 that the first commercial oil well was drilled in Romania. The first commercial well capable of mass production was drilled at a site known as Spindletop in south eastern Texas. This site produced more than 10,000 barrels of oil per day, more than all the other oil-producing wells in the U.S. combined. Many would argue that the modern oil era was born that day in 1901, as oil was soon to replace coal as the world’s primary fuel source. Oil’s use in fuels continues to be the primary factor in making it a high-demand commodity around the globe, but how are prices determined?
The two primary factors that impact the price of oil are supply and demand and market sentiment. The concept of supply and demand is fairly straightforward. As demand increases (or supply decreases) the price should go up. As demand decreases (or supply increases) the price should go down. The other key factor in determining oil prices is sentiment. The mere belief that oil demand will increase dramatically at some point in the future can result in a dramatic increase in oil prices in the present. Of course, the opposite is also true and can result in a dramatic decrease in prices.
Regardless of how the price is ultimately determined, based on its use in fuels and countless consumer goods, it appears that oil will continue to be in demand in the long term but understanding what these price changes indicate is important.
How does the price interact with the world’s economy?
There appears to be a 29-year (plus or minus one or two years) cycle that governs the behaviour of commodity prices in general. Since the beginning of oil’s rise as a high-demand commodity in the early 1900s, major peaks in the commodities index have occurred in 1920, 1951 and 1980. Oil peaked with the commodities index in both 1920 and 1980. In addition there have been four major recessions in the West since the mid-1970s and each has followed a spike in the oil price. All downturns have their own peculiarities, but one common thread links the stagflation of the seventies to the mega-crash of 2009: dearer crude oil. The opposite also applies. A low oil price was a vital ingredient in the post-war Golden Age, and a falling oil price lubricated the strong and sustained growth of the 1990s. Logically, therefore, the 28% decline in the cost of crude since June should mean higher levels of activity and the possibility of a return to growth and prosperity. For that to happen, however, many analysts believe the oil price will have to fall a lot further, to somewhere around $50 a barrel.
The main drivers of this recent fall have been higher oil output coupled with weaker demand from China and Europe. The US also now produces 65% more oil than it did five years ago following the boom in shale production and Fracking. The rise has contributed to the global glut of crude and allowed the US to import 3.1 million fewer barrels of oil a day compared with its peak in 2005. Prices are now well below the level on which many oil exporters have based their budgets. At $115 a barrel the price was consistent with high levels of demand. Oil has averaged $103 since 2010 – trading mostly between $100 and $120 – so a continued period of weak prices i.e. $80 or less, which many forecasters see as a distinct possibility, would have an impact across the world, and from multiple angles.
Winners and Losers
The winners in this environment are the large net importers of oil such as India were commodities account for 52% of imports but only 9% of exports; and those that have high inflation rates, such as Turkey. Business costs will fall and consumers’ incomes will stretch further. The losers are oil producers, which will see growth fall and budget deficits swell. Iran, subject to a crippling western embargo, needs an oil price of more than $140 a barrel to make its budget break even. Anything below $120 a barrel spells trouble for Venezuela and Nigeria. About $105 a barrel is Russia’s cutoff point. At today’s price even Saudi Arabia, the world’s biggest producer, is starting to feel the pinch as it has used a high oil price to fund generous public spending. It currently needs $93 a barrel to balance the books. The problems are magnified for many of these countries because high oil prices have stunted the development of other sectors of the economy. In Russia, oil and gas accounts for 70% of exports. The country’s struggling manufacturing sector relies heavily on orders from energy companies. The US is also not immune as shale production costs far more than the straight forward pumping of oil and at lower prices will struggle to make economic sense. In general though, Middle Eastern oil is the lowest cost to produce, with some of the largest reserves and typically the more they pump, the lower prices go.
Conclusion
Clearly the current falling oil prices are the result of a glut of supply and an easing of demand from a slowing global economy. The large producers such as Saudi Arabia could try to arrest the decline by cutting production, although a similar ploy was notably unsuccessful in the mid-1980s. Some analysts believe that the Saudi’s would live with sub $80 barrel oil prices if they thought it would help put the Shale oil producers out of business and discourage Russia from pursuing its political agenda regarding the Middle East. In all probability lower oil prices will also force Russia to adopt a softer line over Ukraine, and Iran to come to terms over its nuclear program.
This is where the economics of oil mesh with geopolitics. In an interconnected international economy a lower oil price can lead to a chain reaction as one problem causes other, often not directly related, problems around the globe. And the obvious danger is that the oil price spike (of 2011 and early 2012) may with the fall in price we are seeing now indicate the onset of yet another recessionary period. However, if oil prices fall too far too quickly, they probably won’t stay down for long. With Morgan Stanley announcing this week that it expects oversupply to peak in the 2nd quarter of 2015, an oil price drop may well present another re-entry opportunity for investors to pick up more shares of great oil production and/or oil service companies at a relative bargain.