Crude Freefall

Falling Oil Prices

By G. Allen Brooks 2015-02-19 16:14:54

(Article originally published in Nov/Dec 2014 edition.)

***From Nov-Dec 2014 Edition of The Maritime Executive magazine***
 
The oil price bubble officially burst when Saudi Arabia acknowledged it was cutting prices for buyers in the U.S. and Asia.
 
High oil prices for the past four years changed the face of the North American energy business.  Lower oil prices may be about to take the world’s energy markets in a different direction. Price forecasters and energy company managers are struggling to understand the meaning of the oil price drop since mid-summer. Is it a temporary imbalance between supply and demand or does it signify a more significant shift in global supply and demand curves?  
 
Brent oil prices, the marker for the global oil market, peaked at $115.19 a barrel on June 19. In the U.S., West Texas Intermediate peaked a day later at $107.95 a barrel. From then until November 3, when this article was going to press, Brent fell by 26.3 percent to $84.90 a barrel while WTI’s slide of 27 percent brought it down to $78.77. 
 
These declines are meaningful, although not unusual, given past price corrections. An examination of price movements since the dawn of the petroleum era shows numerous periods of significant declines lasting anywhere from six months to several years.  For example, the first decline extended from 1863 to 1867, starting barely four years after Col. Drake’s well in western Pennsylvania saved the whale population.
 
While today’s correction is only four-and-a-half months old, the shortest significant price decline came during the 2008 financial crisis and subsequent recession. It lasted six months, starting in the summer of 2008 when financial institutions began blowing up and global credit markets stopped functioning. After falling from $143 a barrel to $39, prices stabilized in December and then tried to rally in subsequent months. Each time, concerns over weak economic activity undercut optimism for a rebound in demand. Starting in February 2009, prices began marching steadily higher, eventually reaching the $100 threshold by 2011 where they essentially traded until now.  
 
Riding the Boom
 
High oil prices dominated the first decade of this century and drove changes to the U.S. oil and gas business. They helped propel the American shale revolution, which, in turn, boosted domestic oil output to levels not seen in more than a quarter century. High oil prices lifted the domestic industry’s profits and cash flows. They incentivized companies to employ more drilling rigs and oilfield services that increased demand for oilfield labor with concurrent increases in local support businesses. With employment up, especially for high-wage positions, workers became unabashed consumers.  
 
Due to the shale boom, oil patches sprouted in locations not generally associated with today’s oil industry – Ohio, Pennsylvania and North Dakota. For many locales it has been a new and different experience: heavy truck traffic, exploding costs for housing and food, local government budgets overwhelmed to pay for social services – everything from hospitals, schools and police to social counseling for depression, divorce and substance abuse.  
 
High oil prices created global challenges not directly linked to the oil and gas industry, but the industry did contribute to them. High oil prices pumped billions of dollars into the coffers of Middle East countries ruled by despots. As their citizens came to understand the wealth created and how little flowed to those at the bottom of society, resentment built and exploded in the Arab Spring. Fear of being overthrown forced other despots to unleash torrents of social spending in an attempt to buy peace.  
 
High oil prices have contributed to the creation of the best-equipped and financed terrorist organization – Islamic State. This group has captured oil wells and sells the output on the black market, earning $2-5 million a day to fund its terrorist activities.  
 
High oil prices have spurred energy conservation: more efficient and clean-powered vehicles, reduced driving, and increased mass transit use. With oil prices at $100 a barrel, petroleum companies saw their cash flows and profits mushroom, funding higher capital expenditures to chase the next giant discovery. 
 
Energy company share prices climbed to all-time highs, making executives rich through their stock holdings. The good times in the oil patch attracted a tsunami of private equity money and cheap debt, helping new and existing petroleum companies acquire and expand shale acreage holdings and accelerate drilling to boost production.  
 
During the first half of 2014, energy analysts began to question why global oil prices were so high. The explanation was that substantial Middle East and North Africa crude volumes were off the market due to unrest, which created a supply shortage to meet global demand. But each time more supply was interrupted, oil prices failed to rise, suggesting a sea-change was underway in the oil market. As European economies started slipping into recession, or no-growth conditions, and China’s economic growth fell short of expectations, oil prices began sliding lower this summer.  
 
The Turning Point
 
In recent weeks, prospects for global economic growth have been reduced by the International Monetary Fund. The oil price bubble burst when Saudi Arabia acknowledged it was cutting prices for buyers in Asia and the U.S. This revelation came just as industry analysts predicted that OPEC would soon announce a cut in its export flow. That didn’t happen. In fact, the opposite occurred as Saudi Arabia boosted output. More importantly, Saudi Arabia told industry representatives that it was prepared to accept oil prices in the $80 to $90 a barrel range for up to two years.  
 
The mood of the oil market quickly changed from euphoria over high prices to dirges driven by concerns over growing surpluses, weakening economic outlooks and slack demand.  So where is the bottom for oil prices? No one knows. Industry analysts are spending significant time and effort attempting to discern at what price levels exploration and development activity is curtailed, believing that only when growth in production stops will oil prices stabilize. The analysts are focused on defining the marginal cost of an oil barrel from fields around the world.  
 
At $80 a barrel, certain oil plays become uneconomic, and at lower prices even more global output becomes unprofitable (see accompanying chart). How low a price is needed to shut down sufficient output to reestablish a global supply/demand balance? Many analysts believe Saudi Arabia is attempting to drive prices to levels that shut down U.S. shale oil activity. The nature of shale wells – high initial production and then a very rapid decline – means that ceasing drilling of new wells will quickly lead to falling production. We don’t ascribe to that view.
 
We believe Saudi Arabia linked its oil price cut announcement to the decision of the European Union to not classify Canada’s oil sands output as “dirty” oil, which would have shut it out of the European market. Europe’s economy is weak, so oil demand is down. Europe is shuttering its nuclear and fossil fuel power plants, relying on renewables for electricity. It is cutting consumption of Russian oil and gas while planning on increased LNG imports. Oil sands output is well positioned to seize a share of Europe’s oil market at the expense of OPEC. Blocking new oil sands developments is, in our view, Saudi Arabia’s goal.  
 
Lower marginal cost oil accounts for the vast majority of global production, meaning it will take much lower oil prices to shrink global output. Oil at $80 a barrel or below will impact oil output, but by how much is difficult to know.  
 
Pluses & Minuses
 
Estimates from Adam Slater, Senior Economist at Oxford Economics, are that lower oil prices will translate into a 0.4 percent increase in U.S. gross domestic product within two years, a smaller gain for the EU, but about a 0.8 percent lift for China’s economy, now the world’s largest net oil importer.  
 
Lower oil prices help economies grow by boosting consumer spending. Greater economic activity means an increase in demand. Lower oil prices will also cut the number of people trapped in “energy poverty,” meaning they must spend more than 20 percent of their income on energy. Another positive from lower oil prices is less costly food – from both less energy and lower costs necessary to grow it and move it to market. 
 
Many Asian economies rely on LNG for energy and, since its price is linked to an index of global crude oil prices, countries have been paying very high prices. Lower oil prices, should they last, mean reduced LNG prices for these countries.  
 
The rapid decline in oil prices is signaling that oil markets are transitioning. High oil prices contributed to changing the future of the North American oil and gas industry by stimulating economic growth, boosting energy conservation and driving the shale boom that has yielded an unanticipated rise in U.S. oil production. Low oil prices will alter both North America’s and the world’s oil industry in the future. We can only speculate on what those changes will be. It is too early to know whether in the long term the changes will be positive or negative. Currently, consumers are rejoicing at lower oil prices, but will they be happy a year from now? Only time will tell. – MarEx 
 
If you enjoyed this article please subscribe to receive your copy of The Maritime Executive magazine. 

The opinions expressed herein are the author's and not necessarily those of The Maritime Executive.