[Ok-sus] The price we will pay for cheap oil
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
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
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
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
As one wag put it, on our way to running out of oil, we keep running
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
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.
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
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,
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
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
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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