The Downside of Low Oil Prices

***From Jan-Feb 2015 Edition of The Maritime Executive magazine***

Revelers around the world rang in the New Year with kisses, glasses of bubbly and spectacular firework displays. Most consumers cheered the extra money in their pockets from the collapse in global oil prices in late 2014, which has continued into 2015.

Year-end prognosticators, such as Financial Times economic columnist Martin Wolf, trumpeted the economic benefits to be gained from the price drop. Wolf wrote that a $40-a-barrel price cut meant that $1.3 trillion, or nearly two percent of global GDP, was being transferred from oil producers to oil consumers. He posited that this shift would be beneficial for economies, especially those built on consumer spending like the U.S.’s. 

Savings from lower gasoline and heating oil prices should spur increased spending on other goods and services such as restaurants, new homes and vacations that have suffered through the era of $100-a-barrel oil. Struggling mature economies, such as Japan and those in Western Europe, should get a shot in the arm from reduced energy bills, but also from the knock-on effect of low oil prices. For East Asian economies, which are large consumers of natural gas delivered in liquefied form, their bills are beginning to drop as most of the LNG consumed in the region is priced off indices that incorporate crude oil prices in their calculation. 

Falling LNG Prices

As the largest LNG market, East Asia tends to have the world’s highest LNG prices, reflecting both market demand fundamentals and the distances necessary to transport the gas. Early in 2014, before world oil prices dropped, delivered LNG prices were in the range of $16-18 per million British thermal units, roughly equivalent to a thousand cubic feet of gas. At the start of 2015, spot LNG prices for February delivery were $10/MMBtu, in the heart of winter when gas prices usually spike. Although the Asian spot LNG market is relatively small, the low price is beginning to impact the long-term, higher-priced gas contract market tied to crude oil prices. 

Contracted LNG prices in Asia are under assault not only from low oil prices but also from weakening industrial demand for gas. Japan’s economy has re-entered recession and, despite the heroic efforts of the Japanese government and its central bank to stimulate the country’s economy, demand remains weak. Additionally, low oil prices have actually made it cheaper for Japanese utilities to burn oil rather than more expensive LNG. And the fact that several nuclear power plants are returning to service will further weaken Japanese LNG demand. 

The dynamics of the Asian LNG market are further altered with the start-up of new LNG export facilities such as Australia’s Queensland Curtis terminal. It’s the first of seven new LNG export facilities to come on line Down Under between now and 2017, adding 86 billion cubic meters of new supply and possibly allowing Australia to overtake Qatar as the world’s largest supplier of LNG. 

The growth in global LNG supplies comes at the same time China entered into long-term deals with Russia for natural gas from western Siberia. Those two deals – one for 36 and another for 30 billion cubic meters of gas annually – set a price of $9.90/MMBtu. At the time the agreements were announced, observers believed that the contracted price would not only put downward pressure on Asian LNG prices but could become the benchmark price.

With new gas supplies secured, China cancelled construction of several planned LNG import terminals and declined to purchase LNG export capacity from various proposed terminals in the U.S. and Canada. One victim of the collapse in oil prices and the subsequent decline in Asian LNG prices has been the deferment of an offshore LNG export facility targeted for the upper Texas Gulf Coast and designed to tap output from the prolific Eagle Ford. 

Slowdown in China?

China’s shifting gas market dynamics are mirrored in the country’s oil demand. Between 2009 and 2013, China’s economy boomed and oil demand climbed an average 6.5 percent per year. With the official economic growth target for China now set at seven percent, oil demand growth will be lower – now estimated at 3.5 percent per year.

In 2014, China watchers put the country’s oil consumption growth between 1.1-3.4 percent, helping to contribute to the global oil glut. That growth may have been boosted by China’s aggressive purchasing of cheap crude oil to add to its strategic petroleum reserve. Those purchases are opportunistic and mask the weakness in Chinese oil demand.

One possible surprise in 2015, according to noted hedge fund investor Doug Kass of Seabreeze Partners LP, is that China’s economic growth may fall below five percent. Another surprise Kass suggests is that China devalues its currency by three percent against the U.S. dollar to help stimulate its economy.

We have already seen announcements of China’s plan for a $1 trillion infrastructure investment program to pump up growth. This initiative is surprising given the government’s statement last fall that it would no longer engage in infrastructure investment stimulus programs. Given the timing of this announcement at the start of 2015, one has to wonder whether the move reflects concern by China’s government that its economy has serious structural weaknesses that can only be overcome by aggressively attempting to pump up domestic demand. 

There are a number of questions about the health of the Chinese economy as it is generally acknowledged that its economic statistics are fudged. Notwithstanding the accuracy of the statistics, industrial production in China is generally thought to have declined in recent months, and the country’s housing boom appears tenuous. The regional banking system has a large volume of bad loans, causing some observers to question whether China may be heading for a financial crisis in the foreseeable future.  With coal mining being cut back as part of the effort to fight pollution and transportation activity also being curtailed, Chinese diesel demand will likely decline as well. 

Closer to Home

Lower oil prices are expected to stimulate economic activity. The question is: “How much will reduced prices hurt petroleum industry activity compared to the benefits they provide for the overall economy?”  Estimates are that U.S. economic growth has benefited by about 0.5 percent annually in recent years from the income and investment of greater drilling and production activity in response to high oil prices. We also know that the energy business has provided the bulk of the economy’s full-time employment gains for the past several years. 

Critics of the fossil fuel business have pointed out that the economic gains by the industry and those states where petroleum activity is concentrated have come at the expense of the rest of the country. But we also know that high petroleum prices have contributed to increased investment in green energy projects. Now, with very low oil prices relative to recent years, the economic benefits and costs are being reversed. But what will be the net result?

An analysis by hedge fund Bridgewater Associates LP suggests that, if oil prices were to stabilize at $75 a barrel for the next year, there were would be a negative 0.7 percent impact on the overall economy’s growth rate. Seabreeze’s Kass points out that the savings from lower gasoline, diesel and heating oil prices will be offset by higher food inflation and rising costs for other living expenses. Kass also suggests that job losses and slowing economic growth will cause consumers to save much of their hard won fuel savings out of fear of an uncertain economic outlook. 

Mike Lewitt of The Credit Strategist concludes that the negative economic impact from low oil prices will hurt income growth in the U.S. by 1.0-1.5 percent over the next year. In an economy where consumer incomes are barely growing, Lewitt’s analysis suggests tough times ahead for average Americans once the short-term benefits of low oil prices pass.

The low oil price story of 2014 will remain a dominant theme in 2015. Since many people did not understand the role of high oil prices and the corresponding boom in oilfield activity in helping restore the health of the U.S. economy after the Great Recession, they may fail to comprehend how low oil prices may actually hurt the economy. As the impact filters down and consumers experience mounting job losses, lagging income growth and weak consumer spending, they may start longing for higher oil and gas prices. 

It is strange to contemplate Americans, as well as Europeans and Japanese, wishing for the same thing the citizens of Saudi Arabia, Iraq, Iran, Nigeria and Venezuela do – high oil prices! – MarEx