The Gift of Low Oil Prices

Oil May Drop top $20 a Barrel

At the end of last week, Anatole Kaletsky wrote an insightful piece for Reuters – The reason oil could drop as low as $20 per barrel.

Kaletsky writes,

There are several reasons to expect a new trading range as low as $20 to $50, as in the period from 1986 to 2004. Technological and environmental pressures are reducing long-term oil demand and threatening to turn much of the high-cost oil outside the Middle East into a “stranded asset” similar to the earth’s vast unwanted coal reserves. Additional pressures for low oil prices in the long term include the possible lifting of sanctions on Iran and Russia and the ending of civil wars in Iraq and Libya, which between them would release additional oil reserves bigger than Saudi Arabia’s on to the world markets.

The U.S. shale revolution is perhaps the strongest argument for a return to competitive pricing instead of the OPEC-dominated monopoly regimes of 1974-85 and 2005-14. Although shale oil is relatively costly, production can be turned on and off much more easily – and cheaply – than from conventional oilfields. This means that shale prospectors should now be the “swing producers” in global oil markets instead of the Saudis. In a truly competitive market, the Saudis and other low-cost producers would always be pumping at maximum output, while shale shuts off when demand is weak and ramps up when demand is strong. This competitive logic suggests that marginal costs of U.S. shale oil, generally estimated at $40 to $50, should in the future be a ceiling for global oil prices, not a floor.

As if in validation of this perspective, Sheik Ali al-Naimi, the Saudi Oil Minister, is quoted in an interview at the beginning of this week

“It is not in the interest of Opec producers to cut their production, whatever the price is … Whether it goes down to $20, $40, $50, $60, it is irrelevant.”

Also, Mr Naimi said that if Saudi Arabia reduced its production, “the price will go up and the Russians, the Brazilians, US shale oil producers will take my share”.

Higher Cost Oil Producers Impacted

Estimates of the cost to the Saudi’s for extracting their oil out of the ground seem to be plummeting, along with the spot price of a barrel of crude. The above interview cited by the Financial Times also asserts that Saudi and other Gulf States can extract at $4-$5 a barrel.

That is an order of magnitude less than the production costs of oil from many US shale plays, much of the North Sea oil supplying revenues to Norway and the UK, as well as Russian and Iranian oil.

Here is a chart from the Wall Street Journal from late October of this year, estimating production costs in US shale oil plays (click to enlarge).

USSalePC

The rig count has been dropping, but many expect US shale oil production to continue increasing, as companies optimize existing wells and drill as long as already secured futures contracts cover output.

Given the low growth to deflationary profile in the global economy, this probably means a glut of petroleum on world markets for 2015 and, possibly, 2016.

Implications of a Period of Significantly Lower Oil Prices

The price of gasoline at the pump in the US is plummeting.

regulargasprice

First-order effects for the American consumer probably more than balance the short-run negative impacts of cutbacks in the oil or shale patch. The typical household gets on the order of $100 extra in their pocket monthly, as long as the low prices continue. This is discretionary money that would have in all likelihood be spent anyway. So other products will benefit, plus people will drive more. It’s as simple as that.

China may be a major beneficiary, since its production is relatively energy-intensive and it is a net importer of petroleum products.

Japan should also benefit significantly.

In Japan, which imports energy (all at prices based on crude oil) worth roughly 6% of GDP, the recent sharp price drop could lift real GDP growth by 1.5%–2%! This would largely offset the 3% hike in VAT imposed last year – or justify the second round 2% hike that was just cancelled. The drop in oil prices may save Abe short term, but it will also put at risk both the 3% inflation goal and the need to turn nuclear facilities back on.

Going Out on a Limb – Business Forecast Blog Prediction

OK, so I’m going out on a limb here and make the following prediction.

As long as there is no banking collapse, as a result of oil companies turning the junk bonds that financed their land purchases into true junk, or the Russian economy collapsing, dragging down the European banking system – all bets are off for a recession in 2015 and probably 2016.

These low oil prices are like a gift to many of the world’s economies, as well as many families reliant on the internal combustion engine to get them to and from work. Low oil prices also should help keep the cost of agricultural products down, again benefitting consumers.

My intuition is that this is a real game changer.

Top graphic from Wall Street Daily

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