The popular myths about today’s low oil prices
An important and widely reported downward trend for oil prices started in July 2014, continuing today with the price per barrel dipping below $30. This followed a prolonged period of high oil prices over the last decade, caused largely by a significant increase in global supply coupled with slower than anticipated growth in emerging economies. The sustained drop in oil prices has generated a huge amount of discussion, media coverage and analysis, much of which has been oversimplified or one-sided.
Some have even resurrected old theories about ‘peak oil’, disproved years ago by new developments in exploration and production. My concern about all this is the false impression given to large numbers of people who have not followed energy industry developments closely. Let me address a few of the most popular myths.
“A falling oil price is bad news for the economy…”
Quite the opposite, a very significant drop in the oil price has never resulted in global economic downturn. On the five occasions between 1982 and 2002 where the price of oil dropped more than 50%, global growth accelerated. On this occasion, the increase in global growth attributed to the oil price drop is estimated around 0.5% of global GDP, less than the equivalent increase deriving from the 1985-1986 oil price drop but still quite significant.
Although we should not rely on past data to make conclusions for the future, there is a reasonable explanation as to why a significant drop in the price of oil might be good news for large parts of the global economy. In many ways, the transfer of funds when the price changes is a zero sum game. With 95 million barrels per day (bpd) of global oil consumption, a $50 decrease in the price redistributes nearly $2 trillion annually to consumers and away from oil producing countries. Consumers tend to spend money more quickly than Governments thus boosting consumption (and growth) in the short term. Of course oil and gas production and the economies of net exporting countries are affected negatively, however the net result is largely positive.
“If not the whole economy then it must be bad news for the energy industry as a whole…”
Upstream is of course severely affected when the price of oil drops, but most of the downstream sector (i.e. refining, marketing, distribution and trading) has been affected much less, because the economics that govern it are very different to upstream.
Most large Oil & Gas companies are integrated across the upstream and downstream value-chain and downstream profits are not even close in balancing upstream losses.
Many people look at the performance of the super-majors and assume the whole industry has collapsed.
However if we break down the industry into segments based on the product lifecycle –from source to the end consumer, the data tells a story. Indicatively, since the oil price started to drop in 2014, the S&P Commodity Producers Oil & Gas Exploration & Production Index has dropped by 60.5% while the S&P 500 Oil & Gas Refining & Marketing sub-Index has remained at the same price levels and the oil price has dropped by 76%. The downstream sector is clearly doing better with low oil prices in comparison, at least in this current period.
“The laws of supply and demand will naturally bring the price into a higher equilibrium…”
The law of supply and demand will eventually work, the big unknown here is when and to what extent balance will be achieved. Unlike an increase in demand where the impact on price is instant, supply is more a factor of time.
Time is important to supply because Oil & Gas projects tend to be large, capital intensive, take many years to develop and have a long life (and more so in conventional than in shale). Therefore changes in supply take a long time to come into effect.
Importantly though, as supply comes on stream and prices fall, demand does not rise proportionately.
Demand for oil is highly inelastic in the short term.
When prices fluctuate consumers do not necessarily change their consumption patterns, and oil is subject to duty in many countries with changes in price ‘at source’ not having a corresponding impact on price ‘at the pump’.
What is certainly true however, is that we will not run out of hydrocarbons any time soon. Putting any environmental debate to one side for the moment, advances in exploration and production enable previously out of reach reserves to be exploited (arctic, deep-water, tar sands, shale etc.), so whatever the demand is over the long term, oil and gas supply can be sustained assuming it is economic and responsible to do so.
“OPEC is no longer relevant in an era of low prices…”
Not true. It may be true that some of its members are becoming less relevant due to individual economic and political circumstances, however OPEC still accounts for nearly 40% of global production so it remains significant. However its relevance is doubted by some as it does not appear to act collectively to ‘ensure the stabilisation of oil markets’ as its mandate states.
What is important to keep in mind is that OPEC member states have some of the cheapest oil reserves in the world.
On average for OPEC, the production cost per barrel is approximately $20, whereas for US shale the break-even price is around $50-55 (with a range between $40-$90) and for deep water or unconventional oil reserves, the cost can go up to $100. This means that in a sustained low price environment, OPEC oilfields will keep producing whilst other more expensive sources of production will stop and this will increase OPEC’s relevance rather than decrease it.
The real danger for OPEC in an oversupplied market where prices remain at these levels, is that the higher cost producers might effectively reduce OPEC’s current role as a ‘swing producer’. A swing producer is able to increase or decrease commodity supply, and is thus able to influence prices and balance the markets for any given commodity, in this case oil. In a demand-driven or undersupplied market like the one of the last 10 years, any increase or decrease in production by OPEC moved prices up or down significantly as it controlled the only spare production capacity in the world. Everybody else was simply producing at maximum levels. When prices are at such low levels as we see today, if OPEC reduces its production to increase the price to e.g. $50, then a number of suppliers would jump in and start producing again. With so much spare capacity becoming economical at various price levels (from $40-$100) OPEC will have difficulties using its oligopolistic power to increase prices as easily as it could in the past, as it is no more the only owner of spare capacity in the market. Conversely OPEC has the cheapest reserves and so it still has the power to increase production and influence prices downwards. OPEC could be in danger of paradoxically increasing its market dominance whilst losing some of the political influence that being the swing producer entails.
I hope that this helps to provide clarity on the recent issues in the industry and a better understanding of the implications of the oil price drop. In contrary to the popular myths that have emerged, the aftermath of this has not been far from what was anticipated. The reason is that this price drop is driven by economics and not geopolitical events which are more difficult to predict and respond to. Investment in Exploration & Production dropped from $700 billion in 2014 to $550 billion in 2015 and plans to develop high cost reserves are being revisited. The drop has boosted global economic growth, yet less so than in the past as the world economy is less dependent on oil than it was 30 years ago; while OPEC is still the most powerful price influencer.
Could this change if the low oil price environment is sustained for another e.g. two years? Of course it can. The longer prices remain low, the larger the impact would be. M&A activity in the industry will intensify and economies that are heavily dependent on oil revenues will struggle (e.g. Venezuela).