Oil prices and the new normal
A great deal of attention has been paid to the plummeting oil price in recent weeks. Markets have swooned as crude has plumbed new lows: Brent and West Texas Intermediate are routinely trading below $30 a barrel, prices unheard of in over a decade. Markets seem to think low prices are here to stay: oil price futures are trading in the mid-40s for 5 or even 10 years; some bearish analysts have argued it might even drop to $10, though most consensus forecasts by investment banks price oil in the $30-50 range going forward. For now, demand remains soft and inventories continue to be resilient, leaving no immediate end in sight to low prices.
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No end in sight (Source: EIA)
This is a dramatic fall from prices of only 6 months ago, which were more than double current prices, and from the prices north of $100/barrel seen within the last few years. The reasons for this drop are tied to changes in both supply and demand on a structural and cyclical level. Should these trends continue, as seems possible for many factors, we may be looking at a prolonged period of low oil prices not seen since the great oil glut of the 1980s. This post will examine the causes of free-falling crude prices, the potential for reversals in these trends going forward, and the profound effects of cheap oil on the world in the coming decade.
Softening demand: temporary blip or secular stagnation?
First, demand for oil has been slack of late. Particular culprits are in the developing world (notably China), where faltering economic growth has eased the insatiable energy- and commodity-hungry titans dictating prices for the last decade. Although China theoretically is aiming for a modest but still rapid growth rate of 6.5% over the next five years, many view this target as ambitious. Growth in other large non-OECD economies has disappointed of late due to a variety of cyclical and structural factors, especially in Brazil and Russia. Many developing economies are reeling from looming debt crises brought about by the strong dollar bringing about mismatches between dollar-denominated debt and local currency-denominated earnings; furthermore, capital has been flowing out of the developing world to the US in anticipation of higher interest rates, meaning the hangover is unlikely to be brief. Indian demand is likely to pick up with solid growth and a burgeoning middle class, but from a relatively low base that will not have a strong impact on prices for some time to come.
In the rich world, demand growth has been anemic during the recovery, especially in Europe. US demand is picking up somewhat (as solid sales of light trucks last year attest to), but ongoing improvements in fuel economy standards and flat or slightly increasing miles driven suggest demand growth may take some time to recover, if it ever does. It is likely that demand will pick up if oil prices remain as low as they are, though with a substantial delay – as it is, US demand is no longer the most important factor in determining oil prices; to an extent, the US have become price takers, not price makers. There are some bright spots on the natural gas side: in attempts to use cleaner power, many countries have been switching to (cleanish) natural gas over coal or nuclear power.
So in the medium term, it is likely that demand growth will remain subdued. If attempts to decarbonize economies gain steam over the next decade, demand may even plateau in the coming decades without ever reaching the scorching growth rates seen in the past.
Strong supply: the collapse of a cartel, and a new swing producer
Probably the two biggest events that have defined the price of oil for the coming decade are driven by supply in the two largest producers, the United State and Saudi Arabia. In the US, the shale revolution has dramatically revitalized US oil and gas production after years of declines and stagnation. Though break-even prices for most wells appear to be ~$60-70, fracking has put millions of more barrels per day on the market and likely precipitated the dramatic increases in inventories that led to falling prices. In the wake of sustained low prices, some heavily indebted fracking firms have gone under, and the number of rigs (though not production) has substantially decreased. Though the lifetime of an individual well is much shorter than with traditional oil wells (thereby making supply more responsive to pricing), innovation among US frackers has been inexorably decreasing production costs, bringing breakeven prices lower and lower. It’s unlikely they’ll ever reach $30, but the US looks to be the world’s new swing producer: as prices rise into the break-even territory, aggressive increases in production will drive inventories back down. Production is quite elastic, and technology continues to improve, so the shale revolution is here to stay.
With appropriate regulatory conditions, it is likely that shale technology can be exported to other countries with favorable geology as well, contributing to a large increase in exploitable reserves that may put a ceiling on prices for the foreseeable future. Given the recent changes in the US allowing exports of crude and LNG, we expect the role of the US as a new swing producer to be cemented in place.
The second major development has, of course, been Saudi Arabia’s gambit to keep production high in the face of dropping prices. Saudi, as the most important producer in OPEC, has used the cartel to manage supply and keep prices moderately high and stable. In recent years, however, OPEC has become increasingly irrelevant – political instability in some OPEC countries has hit output while non-OPEC producers have grabbed market share – notably, four of the five largest oil producers are not in OPEC. Recognizing this fact, Saudi Arabia has opted to try to price high-cost producers out of the market and gain market share through aggressive exploitation of their low-cost reserves. This has worked, to an extent (see above re: US shale producers), but has also caused substantial harm to the budgets and current accounts of OPEC members (among others). Saudi can manage this turbulence for quite some time, but other members of the cartel are hurting. The lack of agreement on curtailment of production even in this strained environment suggests no decreases in supply are forthcoming. The recent increase in tension between two major OPEC producers, Iran and Saudi, make the prospect of a deal even less likely.
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OPEC on the sidelines (Source: EIA)
Even if the shale revolution and Saudi’s bid for market share are putting downward pressure on prices, do political developments elsewhere suggest the supply glut is temporary? Unfortunately for oil producers, the answer is likely no. Political instability has cut oil production in some countries, at least temporarily – notably this includes Iraq and Libya, and to a lesser extent Syria. Nevertheless, these were not major producers to start with (Iraq’s production had only started to recover in recent years from years of sanctions, war, and underinvestment), so any improvement in production is mostly a bonus. Furthermore, Iran has heretofore been largely excluded from investment and oil markets due to punishing sanctions, is bringing quite a bit of supply and production online.
There are some expensive and marginal projects in other countries that may be hurt by a variety of political and economic factors: Brazil’s pre-sal fields appear to be expensive and difficult to exploit, and Petrobras is embroiled in a major corruption scandal. Mexico’s expected production increase with the recent auctions of blocks to foreign oil majors may not pan out depending on the structuring of concessions, geology, and the economic cycle. Venezuela’s political uncertainty may limit investment and future production. Even so, these factors are relatively local matters and are not likely to all end up having a negative impact on supply.
Where to?
So what does this mean? Stagnant or modest demand growth coupled with abundant supply is likely to keep oil prices low for the medium term. Absent buoyant global growth or a dramatic supply shock, this appears to be the new normal. The effects of this are likely to be myriad and profound on several levels: economic, political, and environmental.
Economically, low oil prices are likely to be mildly stimulatory and deflationary to advanced economies. Given that the US economy has relatively low energy intensity, the effect is likely muted, but we may see a modest increase in consumer spending and decreases in inflation. The data on the effect on consumer behavior has so far been equivocal. While some factors point to buying decisions that change with oil prices – such as the aforementioned improvement in light truck sales – in general consumer spending has not increased as much as expected with the decrease in energy prices. Inasmuch as low energy prices lead to near-deflation in the US and EU, it may even further complicate monetary policymakers in their bid to increase inflation rates from the unprecedented zero bound.
In the developing world, economic effects may be more pronounced on energy and transport prices. This is particularly relevant now that many countries have used the opportunity afforded by low prices to eliminate or reduce wasteful energy subsidies (see: Indonesia, India, Egypt, etc.). This is politically impressive, fiscally prudent, and also will make demand in these economies more responsive to changes in price, further moderating any future upward pressure on the oil price. Greater fiscal flexibility and lower consumer outlays on energy will help these economies weather the economic headwinds they are currently experiencing.
Oil producers, however, will face severe economic and political challenges. This is particularly relevant in undiversified economies with high break-even costs that rely heavily on oil production (see: Venezuela et al). Many authoritarian oil producers have an unwritten compact with their citizens, that governments will continue to restrict political freedoms and remain in power in exchange for generous welfare states financed by oil revenues. This model is falling apart across many oil producers, especially in the Middle East. Political instability is almost certain to follow; those best placed to avoid turmoil are those with low production costs and solid fiscal footing (see: Saudi Arabia, Kuwait). Even so, the transition is likely to be wrenching and a welcome wake-up call to diversify the economy.
More diversified economies will likely fare somewhat better – Russia, Brazil, and Mexico all have substantial non-oil components to their economy, even though each has found petrodollars very helpful in balancing budgets and keeping citizens happy. Even so, it is likely that prolonged periods of low prices will increase political instability, albeit in a more muted manner.
Environmentally, low oil prices will probably make the shift to a low-carbon economy all the more difficult. Without clear pricing signals, it is going to be hard to decrease consumption dramatically. Governments in developed countries should seriously contemplate instituting carbon taxes now to offset potential increases in demand. The inflationary and growth-sapping effects will be muted given the currently-low oil prices, and the fiscal fillip will always be useful in a world of highly indebted governments.
In conclusion, low oil prices brought on by a serendipitous confluence of secular and cyclical factors offer us an unprecedented opportunity to fundamentally change the arc of oil consumption in the world. Eliminating subsidies and instituting a carbon tax would have muted impact on consumers at present while substantially improving the fiscal positions of governments. Attempts to hasten the plateau or decrease in global demand may allow for supply to continue to outpace consumption, further extending the secular decline in the oil price. Meanwhile, pressure on authoritarian producers may encourage them to clean up their fiscal positions while acknowledging the political aspirations of their populace. This is an optimistic view; certainly a mismanaged inflection point in the oil market could result in disaster and global instability. Yet if this opportunity is seized, the age of cheap oil may be here to stay as we transition to a low carbon future.
