[Ok-sus] The price we will pay for cheap oil

Bob Waldrop bob at bobwaldrop.net
Tue Oct 28 14:40:26 UTC 2014


More discussion of the impact of Saudi Arabia's "price war" on oil.

Bob Waldrop, OKC

http://www.advisorperspectives.com/newsletters14/The_Price_We_Will_Pay_for_Cheap_Oil.php

The Price We Will Pay for Cheap Oil
October 21, 2014
by Richard Vodra

The world price of oil – Brent Crude – fell below $84 per barrel on 
October 15. This was 26% less than the $115 it had reached in June, just 
four months before. The rise during the spring had many explanations: 
global tensions in Ukraine, the South China Sea and especially the 
Middle East with the emergence of the Islamic State, plus a capital 
crunch challenging the health of the U.S. shale fracking boom. Then 
suddenly in June, prices started dropping, reaching levels unseen since 
2010 (though still high by historical standards – twice that of 10 years 
ago).

What is going on? Why does the price of oil matter to financial 
advisors? What might these fluctuations mean to the price and supply of 
oil for the rest of the decade? Isn’t oil just another commodity?

A primer on oil prices

Oil is unique. There is a tight relationship between energy supplies, 
especially affordable quantities of oil, and the level of overall 
economic activity. Simply put, economies stop growing when their use of 
energy stops growing. The world moves with oil, and petroleum lubricates 
the global economy. It is not simply a natural resource, but the 
substance that allows all other systems – from food to cities to 
(unfortunately) war – to exist at the massive scales of today.

For most of the 20th Century, the world’s supply of oil grew steadily, 
while the price generally declined and remained low1. This enabled the 
world’s GDP to expand by a factor of 15, a rate vastly greater than at 
any time in human history. The opening years of the 21st century have 
broken with these trends. The price of oil is higher (even adjusted for 
inflation) than it has been since the opening days of the oil age 
(except for a few brief periods), but global supplies of oil are growing 
very slowly, if at all, and economic growth is stalling all over the world.

The booming story of American shale oil development and the prospect of 
“energy independence” had been a defining narrative driving optimism 
about our economy since 2009. Many advisors have bought into this story, 
which depended on enjoying both our new oil and high world energy 
prices. The current price collapse could be a threat to that part of our 
prosperity.

Oil extractors need high prices. The cost of getting oil out of the 
ground has been rising at more than 10% per year for over a decade as 
the new sources of oil moved to deep water, tar sands and shale 
deposits. In addition, many nations, especially Russia and those in 
OPEC, need the revenue from oil to pay their national bills and support 
the promises made to their people and their militaries. The break-even 
price for those producers is approximately $110 per barrel for Brent, 
and that was the regular price from 2010 to this summer, bouncing around 
in a tight range.

A quick note of explanation: the most common global price for oil is 
Brent Crude as traded in London. The most common American price, and the 
one quoted in the papers and on CNBC, is West Texas Intermediate, or 
WTI, delivered to Cushing, OK, and traded in New York. Historically, 
Brent and WTI traded within 1% of each other, but as US and Canadian 
extraction has grown relative to the rest of the world, WTI now trades 
at a discount to Brent. The average price paid by US refineries is 
closer to Brent than to WTI, so that price is what this paper uses.

Oil demand is pretty inflexible over short periods (less than a few 
years), except when a sharp economic crisis hits, as in 2008. Most of 
the time prices are set by the price sellers are willing to accept, as 
measured by the cost of the marginal barrel. Ever since the 1870’s, the 
challenge facing oil producers has been to control and “coordinate” 
extraction rates to boost prices, but not higher than the buyers could 
afford.

As one wag put it, on our way to running out of oil, we keep running 
into oil.

Historically, producers have been pretty successful at this control, 
from Rockefeller’s Standard Oil monopoly to the global cartel of major 
companies to the regulation by the Texas Railroad Commission to the 
emergence of OPEC. In the first years after 2000, both supply and prices 
rose sharply to meet global demand, but since about 2005 world crude oil 
extraction rates have been flat (plus-or-minus 5%) despite even higher 
prices.

Saudi Arabia has long been considered the “swing producer,” the only 
potential source of extra supply or reduced production, while everyone 
else pretty much extracts as much as they can as fast as they can. When 
the Saudis raise or lower their output to keep prices stable, others 
enjoy the benefits of the new prices. The Saudis have been willing to 
exercise this responsibility in exchange for security arrangements that 
go back to FDR, Henry Kissinger, and Jimmy Carter.

What’s changed?

It appears the Saudis are abandoning this role for now, and are instead 
engaging in a price war. News reports, always citing “unnamed sources,” 
suggest the Saudis are willing to let prices drop to the $75-80 range 
and keep them there for a couple of years to protect their market share. 
It is also possible that this is a short-term dare to encourage the U.S. 
and OPEC nations to share in price-supporting cuts. We will know soon, 
but the impacts grow the longer the prices remain low.

The best known supply of new oil is the “light tight oil” (LTO) 
extracted by fracking operations in Texas and North Dakota, which has 
represented one of the few sources of growth in world oil supplies since 
2005. This oil brings several problems to the markets. First, a large 
number of independent companies are involved, and they are not subject 
to the informal rules of the market that have controlled output for 
decades. Instead, the wells are financed with borrowed money, and need 
rapid production to cover cash flow requirements. Further, the fracked 
wells deplete rapidly – on the order of 60% per year – so there is a 
need for new wells (a “drilling treadmill”) to keep things going. 
Finally, the oil is in the wrong place (North Dakota) or of the wrong 
type (very light) to be economically used by existing refineries on the 
Gulf coast. The U.S. has been very proud of this new production for 
reducing our need for imported oil. Some LTO may be profitable at prices 
down to $60, but in June Goldman Sachs estimated a break-even price for 
this industry at $85 in WTI, which is already higher than the current 
price (see here and here).

Canadian tar sands oil is also expensive to produce and transport, 
requiring over $100 per barrel for new projects, according to a recent 
Canadian study. Without high prices and the Keystone XL pipeline, much 
of that oil may remain in the ground.

Another problem for the Saudis is the amount of unauthorized oil 
sloshing around in world markets. Nigeria reports up to 500,000 barrels 
per day that is stolen and sold on black markets. Islamic State finances 
some of its operations through stolen oil. Russia and Iran are reported 
to have barter arrangements designed to skirt economic sanctions. 
Kurdistan is selling some oil directly rather than through the Iraqi 
government. The situation in Libya changes from week to week.

The impact of low oil prices

While the changes in the global oil market have been at the margins 
(U.S. LTO amounts to less than 5% of total global volume, and has mostly 
just offset cuts in Libya and elsewhere), the overall picture could be 
alarming to the Saudis. As the U.S. extraction grows, the amount we 
import from the Middle East declines, so the Saudis need to find new 
markets for their oil. Russia wants to sell more oil to China, and the 
Saudis would like to reduce that threat.

In the United States, there were already efforts to allow the export of 
U.S. crude oil, even though we still import oil. As prices decline, more 
pressure is placed on expensive oil producers, which can be expected to 
add to the arguments for exporting. The introduction of U.S. crude 
exports – we already export finished products like diesel – would bring 
U.S. prices up to world levels, benefitting producers at the expense of 
oil users like refineries, manufacturing plants, and the drivers of 
American cars. The drumbeat of “American energy abundance” requires 
higher, not lower, prices.

Further, the Saudis have a number of political scores to settle. To the 
extent that the fight against Islamic State is seen by them as part of 
the larger Sunni-Shia conflict, they cannot be happy to see the U.S. on 
the same side as the Shiite governments of Iran and Iraq. Russia has 
never been an ally of the Saudis, and they are helping Iran, the Saudi’s 
biggest enemy, avoid Western economic sanctions. Thus, adding price 
pressure to Russian oil exports may be one of the main objectives of 
this price war. Russians admit that the Saudi-led efforts in 1986 that 
cut prices below $10 contributed importantly to the collapse of the 
USSR, and some fear a repeat. Russia’s budget is based on an average oil 
price of $100, so the current levels hurt them a lot.

Low prices, while they last, will help the economies of oil importing 
countries, including Europe, Japan, China, and India. Many of these 
countries are teetering on the edge of recession or are facing slower 
growth rates, so the impact could be significant. The overall effect in 
the U.S. may be neutral, hurting oil extraction efforts and the 
economies of Texas, North Dakota, and Oklahoma, but helping average 
people who will see cheaper prices for gasoline at the pump and lower 
shipping costs. Oil exporters (OPEC and Russia) will face budget 
pressures, as many of them finance much of their social spending from 
oil revenue.

If these price cuts are a strategic move by Saudi Arabia, the biggest 
impact will be several years out. The major international oil companies 
– Exxon, Shell, Total, BP, and a few others – are the only firms capable 
of making the financial and technical investments needed for major 
efforts such as deepwater projects, drilling in the Arctic and 
developing the Caspian Sea basin. However, as costs have risen, they now 
need to receive $130 per barrel of oil for an adequate return on their 
money. They were already cutting back on their capital expenditure 
budgets with $110 oil. These new lower prices will discourage them 
further, and the oil that these projects would be yielding at the end of 
this decade will not appear on the market.

Similarly, U.S. shale oil efforts need prices well above $80, and many 
operating companies were already under severe cash flow pressures with 
$100 oil. The lenders who have financed these companies over the last 
five years may be reluctant to continue if prices are low or uncertain. 
Watch for a decline in new drilling, made worse by the coming of winter 
to North Dakota. The threat to oil production in Canada is even worse, 
as several firms have delayed or cancelled new operations. A lot of oil 
that is expected on the market from 2015 to 2020 may “go missing.”

The large oil service companies like Halliburton, Schlumberger, and 
Baker Hughes have been thought to be a lower risk way to invest in the 
oil business, but they will be pressured as capital spending is scaled 
back by exploration and production firms.

The long-term implications for advisors

Cutting back on future oil extraction might seem a good thing for the 
fight against climate change, because climate activists have been urging 
steps to keep fossil fuels in the ground. It is a double-edged sword, 
though.

Low fossil-fuel prices will slow investment in wind and solar power. 
Electric cars, small cars, and hybrids might be attractive if gasoline 
is $5 per gallon in the US, but less so at $3. Relatively cheap oil 
could also hinder China’s investment in promoting more electrified 
transportation as a way to deal with its pollution concerns. An 
investment that assumes the use of fossil fuels, whether a power plant, 
a pickup truck, or a parking garage without charging stations, will 
delay the conversion to alternative energy for the life of that asset.

Confusing the climate challenge could be another Saudi goal. If the 
energy conversion process away from fossil fuels is done in time, the 
global community can possibly avoid the levels of CO2 and other 
climate-forcing substances that we now know will lead to dangerous 
temperatures and weather in the future. On the other hand, if that 
conversion is done quickly, the main assets underlying the economy and 
society of Saudi Arabia and many other nations, as well as the owners of 
many energy companies in the US and elsewhere, may become stranded and 
worth much less.

Looking ahead, then, it is plausible that the current oil supply glut 
will lead to a shortage of oil, and higher prices, by the end of this 
decade, while actions that could have produced useful alternatives may 
not occur. The current oil price disruption has many possible causes, 
objectives, and effects, including challenges to the political stability 
of Russia and many OPEC nations, as well as to the shape of the energy 
industry over the next decade.

This is only a preview of the magnitude of changes we should look 
forward to, economically and politically, in the years ahead. Financial 
advisors will have to avoid committing their clients too firmly a 
specific outcome.

Richard E. Vodra, JD, CFP, is the president of Worldview Two Planning in 
McLean, VA. He is also a board member of the Association for the Study 
of Peak Oil and Gas – USA. He can be reached at rvodra at worldviewtwo 
dot com.

-- 
http://www.ipermie.net How to permaculture your urban lifestyle and adapt to the realities of peak oil, economic irrationality, political criminality, and peak oil.



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