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Why the price of oil is falling and what then?

tammikuu 16, 2015

Routledge, the publisher of our recent book The World After Cheap Oil, just published our article ”Why the price of oil is falling and what then?” in their sustainability/energy -blog here.

Enjoy. For us Finns, the article was also published in Kanava-magazine 1/2015 (out 16th January, only available in paper).


Routledge keeps on changing the url so here is the full text:

Why the price of oil is falling and what then?

The authors of The World After Cheap Oil discuss the causes and impacts to the world economy of falling oil prices.

This article was first published in Kanava-magazine 1/2015 (in Finnish).

Our book,The World After Cheap Oil came out just as the price of oil was in a freefall. What irony, we thought. In the book, one of the big questions was ”Why the price of oil stays high even though the western world is in economic trouble, as recession has historically lowered oil consumption and prices?” The two main reasons we found were:

1) The historical peak in crude oil (2008) production and approaching peak in “all liquid fuels” production had tightened the oil markets. The spare capacity, or gap between demand and production capacity, had shrunken considerably.
2) China and several other countries were growing their economies and especially their thirst for oil so rapidly, that they bought all the oil that was released through demand destruction in the western nations (most OECD nations have seen oil consumption dropping from one to several percent per year for the last decade).

In a tight oil market, even a small increase in demand caused a large increase in prices – many times bigger than would have happened in a more loose market with more easy spare capacity to increase production with. As a result, the price of oil quadrupled in a decade to around 110 USD per barrel. Now the price of oil has fallen roughly by half in just six months. Why?

We think there are several reasons at work.

The single most important reason is probably the troubled economy. The global economy has been underperforming for years, with some areas like the EU facing significant trouble for many years. In the last few years, even China has been coughing (economically as well as literally due to their dirty energy mix). Even the official numbers from China, which many say are excessively optimistic, have been steadily declining for the last two years or so. The proposed future engines of the global economy – the BRICS countries – have also been in trouble. The latest and most significant example of course being the crashing Russian economy. All of this has weakened the global demand growth (actual growth and future predictions) for oil for several years already, making the market less tight.

The second important reason can be found in production. The production growth of tight oil (mainly shale oil) in the U.S. has surprised many. In just a few years, it has grown to well over three mbpd (million barrels per day). Libya has also grown its production somewhat in 2014. This has further increased the spare capacity and loosened the markets, as the ability of the world economy to increase its oil consumption has been rather limited with the recent prices of over 100 USD per barrel. North America has been practically the only place globally where liquid fuels production has grown significantly, with the rest of the world stagnating for the last few years.

Some people have also speculated with various geopolitical moves and motives to weaken the Russian economy and ability to function in the world arena by crashing oil prices. There is not much reason for conspiracy theories however. The oil in North America is mainly produced by private companies, of which many are publicly traded and operate internationally. It would be very hard and risky for politicians to try to influence these companies and try to tell them how to run their operations. The thing is, they don’t have to. These companies do their best to produce as much as possible as fast as possible as part of their normal operation. Many of them are also heavily indebted, so they have little choice.

A third reason is OPEC’s apparent inability to function as a price cartel. Granted, OPEC has never been a very coherent group of countries, but in the autumn of 2014 it managed to touch new lows with its decision not to do anything about the crashing oil prices. Many of the OPEC member countries have grown used, and addicted, to oil prices well north of 100 USD per barrel. They have made their government budgets accordingly. On the other hand, many of the members are on the declining side of their oil production, and so face diminishing export revenues even without price declines. When the cartel fails to find the common will to significantly drop its oil production in order to drive the prices back up, it is easy to see why Saudi Arabia would be willing to do it all by itself – sacrificing market shares and revenues alike. Many of the members might also fear the ability of U.S. to keep on increasing its tight/shale oil production into the future even with lower oil prices, which could negate much of the OPEC’s actions and cost them even more in lost market shares and revenues.

So the oil markets have loosened for the time being, compared for example to the situation during the Arab Spring in 2012 when oil prices rose sharply at the first sign of trouble. Libya has seen a roller coast of production, as its production first increased from 200 000 bpd to almost 900 000 bpd and then fell to around 500 000 bpd, all inside just six months, and without much price shocks. Syria has failed to increase its production, and ISIS is making things more complicated in Iraq, but the price of oil has kept on falling.

Oil is a strategic tool of power, and it has always been a matter of geopolitics. Vladimir Putin has blamed the west for manipulating oil prices and therefore trying to wreck Russia’s economy. There has been little proof of this, but in a historical perspective, this would certainly not be the first time. Back in 1970’s the U.S. with its ally Iran pushed oil prices lower to boost their and their allies’ economies. In 1980’s the Soviet Union faced bankruptcy largely due to low oil prices and revenues, facilitated by Saudi Arabia’s ability to increase production. During the Gulf war in 1990’s the U.S. again asked for Saudi Arabia to pump more oil to keep the markets stable. In the early 2000’s some have suggested that Saudi Arabia manipulated oil prices to weaken Iran’s economy.

Global demand has been stagnating, largely due to economic problems. When the supply was lagging behind, strong demand growth led to large price increases. In the same way, as production capacity has grown but demand is lagging behind, it leads to large price decreases.

What next?

In a slight controversy, cheap oil might prove a more serious problem than expensive oil. The marginal cost of new oil production has grown rapidly in the last few years. Even a year ago, when oil prices were over 100 USD per barrel, many big international oil companies announced that they were cutting their Capex-investments – Shell by as much as 20 percent. A year later, the price of oil is hovering on 60 USD per barrel (at time of writing in mid-December), and many more companies such as ConocoPhillips, are announcing more cuts to their investments. If the companies were facing difficulties with oil prices of 100 USD, one can imagine the trouble they could face with a price of 60 USD. Diminishing investments now will lead to diminishing production in the future.

It has become uneconomical to search and develop new oil in many places. Canada and its oil sands production is facing existential losses as current prices are driving the producers to financial ruin. With tight oil, the situation might also turn bad very quickly. From October to November, new oil and gas drilling permits fell by almost 40 percent. As shale oil production declines very quickly – around 40 percent per year on average compared to 5 – 7 percent on conventional oil fields – the producers have to drill more and more wells faster and faster to grow production. If the drilling slows down or stops, it shows in the total production much faster than in traditional oil production.

Russia has taken the initiative to shoot its oil production and export revenue in the leg, as the ongoing crisis in Ukraine has cut most outside investments just when they were direly needed. Russia’s old oilfields are depleting, and the country’s total production has been on a plateau for a couple of years. In 2014, the production has started to decline, and it is not expected to grow again in at least a few year’s time. Iraq has been seen as the source for most of global oil production growth in the coming years and even decades by the IEA, but it does not look promising with the continuing internal problems. Its production has grown, but it is badly behind schedule. It has been estimated that Iraq would need oil prices in the 120 USD range. The current prices could destroy any hopes of a quick and miraculous recovery.

The world economy, at least the countries that import much of their oil, should get a boost from the low oil prices. But this boost is largely taken from investments to future oil production, which have already been frozen in many places. It might also be taken from the societal stability of current oil exporters. Lower oil prices also hamper investments to oil efficient infrastructure, as they too are dependent on high oil prices to make economic sense. If the low prices continue for a few more months, the demand for oil should start to pick up if economies start to grow (excessive debt might slow this growth however). We could then face a situation where we don’t have spare capacity to grow production to match growing demand, which will lead to rapidly rising prices again, which will eventually crush the budding economic growth. This back-and-forth that hides any clear economic signals of depleting oil production will leave us in a worse shape after every phase. In a situation where we are already at least a decade or two late in building our societies to be less oil dependent, this could be disastrous.

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