January 14, 2015
The recent collapse of oil prices raises questions not only about why, but, more significantly, about whether the new low-price regime will last. The answer on oil, as always, requires a look at three component considerations: (1) actual global demand for oil and gas, (2) actual global supply and (3) anxieties, usually based on geopolitics, about the first and second considerations. All three change constantly, seldom as forecast, but it is the third, the least stable of the three, that causes the sudden, dramatic price moves, including this recent one. Moderating demand and increasing supplies have played a role in the recent drama, to be sure, but the price decline stems largely from an abatement in geopolitical anxieties, at least as they pertain to oil. Such concerns will, however, likely return, confirming the now-well-established historical rule that no oil-price regime lasts long.
Moderated Demand
The demand part of the picture is the most straightforward. The use of oil and gas, in developed economies especially, has grown at a much slower pace than overall levels of commercial activity (or than was forecast at intervals along the way.) To some small extent, this shortfall has its roots in the growth of alternative energy sources—solar, wind, biomass and the like. But, for all the political emphasis and investment interest, this area accounts for the least of the change. According to the Energy Information Agency (EIA), alternatives amount to only 9.5 percent of all energy consumed in the United States. The figure is slightly higher in other developed economies and slightly lower in emerging economics. No doubt alternative development has kept oil and gas prices lower than they otherwise would have been, but not significantly and certainly not with the kind of sudden impact that would account for recent dramatic price moves.
Hydrocarbon efficiencies and conservation have played a bigger role. Even in the 1980s and 1990s, when the global economy was increasing at a brisk pace, efficiencies held the growth of global oil demand to a mere 2 percent a year. In the early years of this century, global energy demand accelerated, largely because emerging economies became a larger part of the picture, and they had neither the infrastructure, nor the wealth to apply the efficiencies that had become commonplace in the United States, Japan and Europe. Still, the application of efficiencies continued. The United States today, for instance, produces a dollar of gross domestic product (GDP) with less than half the oil and gas it required twenty to thirty years ago.
While there can be no doubt that these efficiency gains in North America and elsewhere have made room for recent price declines, the poor performance of the world economy has had a more immediate demand effect. Japan, after a brief surge, has fallen into recession. Europe, under the weight of its fiscal-financial crisis, has also performed poorly. From a technical standpoint, the eurozone may have avoided the recession designation, but it is only technicalities that distinguish its economic performance from recession. China is growing at a much slower pace than previously. Having expanded in real terms at 10-12 percent a year not too long ago, it now struggles to sustain a 7 percent real growth rate. Other emerging economies, including India, have slowed along similar lines. The U.S. economy has accelerated of late, but it is far from apparent that the new, more-rapid growth pace is sustainable.
Rising Supply
More than slowed demand, a surge in global oil and gas supplies has made still more room for price declines. Here, fracking is the star of the show. This technology has increased U.S. oil and gas production by more than half during the last five years. The surge has added fully 4.0 percent to global oil flows since 2009, a not-insignificant difference. In addition, technological advances have also enabled Canada to access its tar sands deposits more cost effectively than in the past. That country has increased its overall production by more than a third during this time, adding another 1.2 percent to overall global output. Meanwhile, other new technologies have allowed producers to get more oil and gas from existing conventional wells, enabling production in some places to pick up even in the absence of new finds.
Beyond such tangible gains, prospective new sources have also factored into future supply assessments and, accordingly, into prices. Playing a large role in this part of the story is a major South Atlantic find made by Brazil’s Petrobras oil company. This Lula field, as it is called, has the potential to add the equivalent of 6.5 billion barrels to known global oil and gas reserves, 13 billion barrels when combined with other new Brazilian fields. When fully developed, these sources should pump the equivalent of 4 million barrels of oil a day onto would markets, a 5.2 percent addition to current global flows. More recently, Australia has announced a shale find that its engineers estimate could increase known global reserves 12 percent. The find is too new yet to yield estimates of production flows. Preliminary Exxon drilling in Russia’s arctic had reported good prospects, though such activity has all but stopped because of the economic sanctions imposed on Russia. Potentials have also gained from the possibility that new conventional extraction technologies will spread from North America to other parts of the world. Russia, engineers estimate, could increase production by 50 percent in this way, even in the absence of any new finds.
Nor will the price declines reduce new North American flows anytime soon. The concern on this front stems from the perception that fracking and tar sands extraction cost more than pumping from conventional wells. To be sure, if prices stay low for an extended time, pumping from these sources might well slow at the margins. But the fact is that tar sands and shale production is not as fragile as some suggest. Production costs can indeed sometimes run high. In some parts of a fracking field, it could cost $90 a barrel to lift oil. But other spots in the same field might cost only $20 to lift the oil. The crucial point is that developers contract for whole fields and for relatively long times. They will, as a consequence, continue to work them entirely for the foreseeable future. On average, engineers suggest, tar sands and shale are largely profitable, as long as oil remains above $50 a barrel, and prices would have to remain below that level for quite some time to have a significant impact on production flows.
Anxieties Rise and Then Fall
This basic supply-demand picture suggests about $60 a barrel as a fundamental market-clearing price— the level that equates fundamental supply and basic demand for oil and gas, all else equal. Such a condition has, however prevailed for some time. Though it has made room for the sudden price drop of the last few months, it certainly cannot account for it. After all, these underlying supply-demand conditions prevailed last spring when prices topped $100 a barrel. An explanation of that seemingly high anomaly and the more-recent, sudden price drop requires a consideration of the third, more-volatile pricing influence—the largely geopolitically based anxieties over supply and demand.
These looked very different only six months ago, when oil prices were uncomfortably high. Russia then had just moved on the Crimea and eastern Ukraine. Many voiced concerns about what the Kremlin would do with oil shipments in response to Ukrainian resistance and Western economic sanctions. At the same time, ISIS’ military advances in Iraq and Syria were at flood stage. Concerns prevailed about what would happen in the then-considered-likely event that ISIS gained control over much or all of Iraq’s oil. Initial ambiguities about Washington’s response to ISIS added to the general anxieties. At the same time, doubts about the course of negotiations over Iran’s nuclear program raised fears that tensions in the Persian Gulf would intensify. Though production gains in the United States, Canada and elsewhere had given long-term hope that global supply would diversify away from these less-than-reliable regions, the unmistakable fact was—and remains—that the Persian Gulf and Russia account for almost 44 percent of global oil and gas output. That fact and this mélange of anxieties understandably prompted markets to bid a considerable risk premium into the price of oil, more than $40 a barrel above the $60 basic supply-demand benchmark at its peak.
The intervening months, however, have seen much of this anxiety dissipate. Washington’s position on ISIS is clearer than it was. These radical jihadists have suffered military reverses, quelling former fears about them gaining control of Iraq’s oil. What is more, it has become clear in the interim that ISIS happily sells what oil it has, raising confidence that the oil would find its way to market, even if ISIS captured all of Iraq’s oil. Also, since prices peaked, Iran and the West have cordially agreed to differ on a nuclear deal, easing oil supply, if not nuclear proliferation, anxieties. And it has become increasingly apparent that Russia is too oil dependent to use it as a weapon, at least not as readily as many feared last spring. The risk premium, accordingly, has collapsed.
Technical Influences and Likelihoods
In this turmoil, technical factors have brought prices below the $60 benchmark associated with underlying supply and demand. A part of this is simply market momentum. When the prices of any asset make as sudden a move as oil has, traders tend to place buy and sell orders to position themselves for a continuation of the trend, and these alone can actually extend the trend, at least for a time. The low prices have also had an economically perverse effect on production. Instead of inducing production cuts, as the textbooks say they should, Iran and Russia in particular have done the reverse. It seems they are so dependent on oil sales for income that they have stepped up production to make up for lower prices. Their behavior stands to reason. Some 80 percent of Russia’s export revenue comes from oil, and the Kremlin depends on oil for 50 percent of its revenues. Figures on Iran are not substantively different. Very little current data exists on their actions, but oil traders provide considerable anecdotal support that these countries have increased sales. Meanwhile, Saudi Arabia, eager to increase the economic pressure on Iran especially, refuses to cut back on its production, as it might have done to stabilize prices in the past. The subsequent oil glut has increased inventories and created acute, immediate, additional downward price pressure.
This kind of movement can carry on for a while, and might even push prices down further. Eventually, the market will clear its excesses and, in the absence of some shock, return prices to the $60 level that reflects underlying supply and demand. But this tidy calculation comes with a warning. It can happen only in the absence of shocks, and shocks, in fact, are likely. The recent dissipation in geopolitical anxieties is far from durable. Neither Russia, nor the Persian Gulf are predictable or reliable places. Putin is a desperate man. Spillovers from Syria’s wars, gains by ISIS, renewed animosity between Iran and the West and a long list of less-definable troubling events in the Middle East could easily raise anxieties again and force oil markets to reimpose a significant risk premium on prices. Today’s new low price is far from secure, much less a new normal, as some have suggested. Any number of headlines could drive prices back above $100 a barrel very quickly, even more rapidly than they have fallen.
Milton Ezrati is senior economist & market strategist for Lord, Abbett & Co. and an affiliate of the Center for the Study of Human Capital at the State University of New York at Buffalo. He writes frequently on economics, finance, and politics. His most recent book, Thirty Tomorrows, on aging demographics, the challenge it presents, and how the world can cope, was recently released by Thomas Dunne Books of Saint Martin’s Press.
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