Ups and downs of Oil prices

by Munir Akram

OIL remains the world’s most critical commodity. It has fuelled the industrial age. For over a century, oil politics has been almost synonymous with geopolitics; the cause of numerous wars and revolutions.

The recent sharp drop in oil prices is a boon to all who import and consume oil. Besides the individual consumer, the price decline has ameliorated the foreign exchange and budgetary fortunes of major oil importers like China, India and Pakistan and could assist in global economic recovery. It has reduced the earnings of major oil exporters, both Opec and non-Opec members.

To a considerable extent, the decline in oil prices has been driven by the laws of supply and demand. Oil (and gas) production has been expanding significantly over the last decade. A major contributor to this has been US shale oil and deep sea production which became viable due to high prices (over $100 per barrel) and technological developments.

The price downturn began with the no-growth in Europe and growth slowdown in China (from 9.5pc to 7pc from 2010 to 2014), India (from 7pc to 4pc over the same period) and Brazil (from 6pc to 2pc). The insipid US economic recovery, fuelled largely by its own oil and cheap gas production, was insufficient to contribute to higher demand. The growing availability of alternate sources of energy — cheaper gas in the US, subsidised wind and solar power (as part of the shift to ‘green’ economies) — further depressed oil demand.

Under the circumstances, it would have been expected that the traditional ‘swing’ producer, Saudi Arabia, would have brought the market into balance by cutting its own sizable production and leading other Opec and non-Opec members to do the same. In fact, Riyadh not only maintained but added 100,000 barrels to its production in the midst of the initial major dip in prices two months ago. This has driven prices further down to below $70 per barrel for the benchmark Brent Crude. At the recent Opec meeting in Vienna, the Saudi oil minister was sanguine, observing that this was not the first time that oil markets had been out of balance.

Most policymakers are wondering for how long this period of cheaper oil will last.
There is considerable speculation about the rationale for the Saudi policy. The most reasonable explanation is that Saudi Arabia aims to preserve its market share by obliging less competitive producers — shale and deep sea oil and alternate energy — off the market. The average breakeven price for shale extraction in the US is $45 per barrel, whereas Saudi costs are less than $5. With prices of around $60 per barrel, production of shale oil and deep sea oil will become considerably less profitable or non-profitable.

Some US shale producers have already shelved expansion plans; several are likely to face shutdown if lower price trends persist. Deep sea production and exploration will also come under pressure as would alternate energy suppliers, unless they obtain state subsidies. Conversely, Saudi Arabia, with $1 trillion in reserves, can sustain lower prices for a considerable period.

Western commentators have conjectured that the Saudi policy pushing lower oil prices is also designed to inflict additional economic pain on its principal regional rival, Iran, as well as Russia, Iran’s major ally in the current sectarian conflicts engulfing Iraq, Syria and the Levant.

A few believe Riyadh is pursuing this course independently, in defiance of the US, to demonstrate its unhappiness with the US overtures to Iran, and to demonstrate its influence in the world economy. Others say that the policy of inflicting further economic pressure on Iran and Russia enjoys Washington’s blessings.

Indeed, the Obama administration’s priority at this time is to secure a favourable deal with Iran on its nuclear programme and cooperation in stabilising Iraq, Syria and Lebanon. Containing Putin and a resurgent Russia in Ukraine and elsewhere is another objective. Whether low oil prices will help to achieve the desired outcomes is an open question.

In any case, cheaper ‘gas’ prices at US pumps and reduced home heating bills will be popular with American consumers; they could also enhance the economic recovery under way in the US. The misfortune of US shale oil producers will not cause Obama any heartache since most are based in the so-called ‘red’ states which are not likely to vote for the Democratic party in the foreseeable future. Reduced shale oil production may also ease pressure on Obama to approve the controversial north-south Keystone pipeline which faces opposition from environmentalists in his party.

The main questions in the minds of businesses and policymakers are: how far down will oil prices go and how long will this period of cheaper oil last?

It is safe to say that lower oil prices are unlikely to prevail over the long term. With growing populations, industrialisation and urbanisation in the developing countries, demand for oil will continue its secular rise until and unless alternate energy sources become much cheaper.

The global oil economy, despite the ‘green’ goals, will be around for several decades. The current lower prices will drive significant production off market and, more importantly, slow down exploration and investment aimed at additional and alternate energy production. Thus, over the medium term, demand will once again come into balance with supply and may even exceed it. Higher oil prices should be expected to return.

For the short term, the price trend cannot be predicted precisely; but some of the indicators to watch for are: a) how rapidly will Riyadh need to replenish its reserves if oil prices remain around $60 to $70 per barrel; b) the extent of production cutbacks brought about by the lower oil price; c) the growth outlook in major economies, especially the US, China, Japan, India and Europe; d) potential disruption of supply from ‘fragile’ producers, eg Libya and Nigeria, and from the Gulf due to spreading turmoil; e) the outcome of the talks between Iran and the West; and f) the denouement of the Ukraine crisis and Russia’s response to economic pressure.

To mix metaphors, consumers should make hay while the sun shines and use this window of cheaper oil to prepare for a future of expensive energy.

Munir Akram writer is a former Pakistan ambassador to the UN.

The article originally appeared in Dawn.

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