Lydia Powell and Akhilesh Sati, Observer Research Foundation
The global risks report for 2016 by world economic forum (WEF) was released recently. Its familiar matrix that ranks risks in terms of likelihood and impact is dominated by environmental, societal and geo-political risks. Only one economic risk makes it to the top five risks and that too only in terms of impact and not likelihood and it is ‘severe energy price shock’ ranked fifth among risks with high impact. Unfortunately there are no explanatory observations on what an ‘energy price shock’ is and why it is important. We will assume that the WEF report is referring to the price of oil because the price of oil is a bench mark for the price of other energy sources as well as a bench mark for global economic performance. The WEF is expecting to be ‘shocked’ in 2016 probably because its earlier expectations of an oil price spike that is listed among the top five risks in its global risks reports of 2007, 2008, 2009 and 2010 is now looking increasingly unlikely.
The price of oil has always been volatile and uncertain partly because of imbalances in supply and demand and partly because interventions for political, strategic and economic reasons. If we look at oil prices from the period beginning from the early 1900s until now, we can see that the price of oil was relatively stable for the longest period of time from 1930 to 1970. This was a time when the oil industry was completely under the control of western global oil majors commonly referred to as the seven sisters. In this period oil traded within a narrow band of $10-20/bbl in real terms. In 1960 global oil majors regulated 90% of world trade in petroleum. There was a fairly high degree of cooperation between producing and consuming countries mediated by the oil majors.
The stability in the oil market mediated and managed by the seven sisters was disturbed when OPEC attempted to redistribute wealth generated by the oil industry in a more equitable manner in the 1970s. OPEC wanted a higher price for oil but more importantly it wanted a higher share of the price. The Shah of Iran is said to have observed that ‘it was an economic aberration that oil was cheaper than a bottle of French mineral water especially in the light of the fact that oil was used to produce more than 70,000 valuable products’.
We will return to the fact that oil now trades at less than a fifth of the price of mineral water later but for now we will continue to look at the history of volatility in oil prices. OPEC’s intervention was justified from an equity perspective as OPEC (producing) countries received only a fraction of the price of oil. But OPEC had to pay a huge price for this intervention. The intervention ignored forces of supply and demand and this resulted in reducing OPEC pricing power. It also destroyed demand for oil and facilitated an increase in non-OPEC oil production in the North Sea and other regions. Though OPEC had decided that the price of oil should be just below the price its substitute, it did not realise that the nearest substitute for OPEC oil would be non-OPEC oil. Cooperation between producing and consuming countries broke down and consequently there was a high degree of volatility in prices.
In the 1980s, forces of supply and demand influenced the price of oil to some extent but this did not mean lower volatility in prices. Prices fell dramatically from a high of $105/bbl (in 2014 dollars) in 1980 to $29/bbl (in 2014 dollars) in 1988. It remained within the band of $20-30/bbl (in 2014 dollars) until 1999. From 2000 the price of oil began a consistent trend of upward growth driven by rapid growth of consumption in China and to a lesser extent in India. Oil demand also grew rapidly in west Asian oil producing economies. Speculation and ‘financialisation’ of the oil market was initiated and this increased fluidity in the market. The result was high amplitude volatility in oil prices. More than 75% of oil resources and 50% of production were with state controlled economies which constrained investment and supply. The dominant presence of state oil companies was a barrier to private risk capital.
Source: BP Statistical Review 2015
Peak oil and other related theories gave rise to a sense of scarcity among consumers. This led to a significant increase in stocking and storage by consuming countries. This in turn removed oil from the market and tightened supply. OPEC power declined in this period as it continuously lost market share to non-OPEC production.
After the 2000s the centre of gravity of demand shifted from OECD countries to non-OECD countries. The unprecedented energy demand from India and China behind this shift was perceived to unsettle the global energy order hitherto dominated by the United States. Until the early 2000s, the United States was a large and growing oil market, the ultimate dream of OPEC producers. Oil imports of the United States were equal to the total imports of China and Japan. The United States was the only player others needed to interact with as it had sufficient market and military power to induce change in the energy system if necessary. China and India were thought to be completely different. Their demand was growing at a time when there are perceptions of scarcity in resource availability and constraints on resource use and was therefore seen to be ‘challenging’ rather than ‘driving’ the global market. China and India did not participate in systems such as the International Energy Agency (IEA) that coordinated cooperation among oil importers. The perception of a new ‘energy silk-road’ between oil producers in the Middle East and oil consumers in Asia generated concerns over an ‘unwelcome nexus’ in the industrialized world.
On the other hand trends such as assetisation of oil properties and financialisation of the oil market continued to grow in significance. There were fears that financial speculation was driving oil prices. Though there was a correlation between oil prices and speculation, causation was not established. The build-up of oil inventories by national governments of consuming countries did not have a stabilising effect on the oil market but it did give the concerned governments a sense of energy security and national security.
The historic relationship between crude inventories and crude prices was broken in 2004. Traditionally high inventories implied low prices (as it is doing now in 2016) but between 2004 and 2008 high inventories meant high prices as filled up storages and stocks implied high perceived risk. This reinforced oil price.
Between 2008 and 2009 a period during which a liquidity crisis in the global financial sector was unravelling, crude prices recorded a ‘shock’ which according to some experts was among the biggest on record. In 2001 the spot average price of crude oil was about $32/bbl (Brent dated in 2014 dollars). By 2008 the average price of crude oil was about $106/bbl which fell to about $68/bbl in 2009.
The cause of the spike in oil prices in 2008 and its subsequent fall in 2009 have been widely analysed. The dominant view is that of strong demand for oil led by developing countries confronting stagnating world production constituting what is generally called a ‘demand shock’. Oil production had begun to plateau in rich producing regions such as the United States, Saudi Arabia and the North Sea. Many experts thought that the time had come for the world to come to terms with peak oil. Best-selling books were written on the impending oil crunch. Financial speculation as the cause of volatility in oil prices was also suspected but this view did not receive widespread endorsement from academic studies. In the early stages of the financial crisis, money leaving other asset classes did go into what many believed to be a one way bet on oil price but when the real world of supply and demand caught up with the financial world, oil prices began to fall rapidly. The uncertainty over the impact of collapsing financial markets reduced expectations of growth and consequently expectations on high demand for oil. On 23 December 2008, the price of crude went down to about $30/bbl.
As the global economy started recovering from the financial crisis, oil prices began increasing. The average price of oil was about $110/bbl in 2013, the highest price achieved since 2010. From the middle of 2013, oil prices started falling and continue to fall. As of February 2016 the price of oil fell below $30/bbl. In general the reasons for this ‘death spiral’ of decline in oil prices are thought to be more specific to the oil market than to the general state of the global economy. During the financial crisis, aggregate demand for all commodities fell which meant that oil price was reflecting the global business cycle. Analysis of the current decline in oil prices shows that it is likely to be the result of changes in the ‘precautionary demand’ for oil associated with shifts in expectations about future oil supply relative to future demand which are specific to the oil sector.
If there are expectations of an economic slow-down in the future, the need to hold inventories reduces which results in a fall in oil prices. The need for inventories can also decline when there are expectations of quick mobilisation of supply in the future (such as US shale production) which could make concerns over oil price spikes and oil supply interruptions irrelevant. The decline in oil prices in the period 2008 and 2009 as well as the decline since 2012 are attributed to oil specific demand shocks. According to one study, if unexpected changes in oil production were the only cause of change in oil prices, crude oil prices should have been in the range of $74/bbl in June 2015. If only changes in aggregate demand (for all commodities and products) affected crude prices, oil prices should have been in the range of $70/bbl in June 2015. If oil specific demand shocks affected prices then oil prices should have been about $65/bbl. The actual price of oil in June 2015 was about $61/bbl.
In general, studies of oil shocks of the past and the present using vector auto regression models have concluded that oil demand shocks rather than oil supply shocks or aggregate demand shocks have made larger contribution to oil shocks. This is an important conclusion that questions the disproportionate attention paid to oil supply shocks by those who look at the oil price problem primarily as a geo-political problem.
Low oil prices may be the result of reasons specific to the oil industry but this does not eliminate the intrinsic link between oil price and broader global economic phenomena. As pointed out by Citibank recently, the value of the US dollar, low commodity prices, weak trade, low capital flows and declining emerging market growth are driving a negative feed-back loop that cannot be intercepted and corrected easily. A very brief summary of Citibank’s argument is that the $6 trillion that was once flowing into the bank accounts of oil exporters is shrinking and consequently what was flowing back to the rest of the world as trade and investment through their $4 trillion sovereign wealth fund (SWF) is collapsing. Oil exporters are experiencing a current account deficit for the first time since 1998 which is limiting the extent to which their SWF can underwrite emerging market liquidity. Citibank says that a 4% strengthening of the trade-weighted US dollar and oil price at $50/bbl could partially slow down the negative feed-back loop. According to Citibank, moves in the opposite direction could lead to what it calls ‘oilmageddon’.
Crude Oil Prices ($/bbl)
Many oil industry experts have argued that at $30/bbl oil production from most of non-OPEC regions is unprofitable. However the business reality on the ground is that production cannot be stopped the moment it becomes unprofitable. There is a cost to moth-balling oil production facilities; debt has to be paid off from oil revenues; man-power has to be kept busy and they have to be paid. This means that oil will continue to be produced even when it loses money.
According to Wood Mackenzie (quoted in the Economist) less than 6% of current production fails to recover costs at $30/bbl. This means that 94% of production will continue to produce even when this means making a loss eventually. Around 3.5 mbp of production is said to be losing about $35 per barrel and yet they continue to produce. According to Wood Mackenzie which tracks production and cost from over 2000 oil fields word-wide, only 0.1% or 100,000 bpd of production has been halted despite a year of low prices.
In the last 18 months, oil prices have fallen by 75% from over $110/bbl to less than $30/bbl. If all else in the economy was going well, this should have resulted in a 0.7 to 3.5% boost to growth on the basis of the rule of thumb that a 10% fall in oil prices boosts growth by 0.1 to 0.5 % is valid. The Economist attributes India’s emergence as the fastest growing economy in the world to low oil prices but India was also among countries that the IMF downgraded in terms of GDP growth forecasts. Surprisingly all countries that were downgraded by IMF were oil importers. There are indications of consumer benefit in the form of increased consumption of transportation fuels in the United States and elsewhere but its positive impact on growth may be cancelled out by job losses. Other impacts of ultra-low oil prices include (a) political and social turmoil in oil revenue dependent fragile nations and (b) much lower incentive to reduce the use of fossil fuels. Coal and natural gas are now ‘dirt’ cheap which means that renewables have to compete harder to beat them as sources of power generation.
It is too early to conclude that the petroleum era is about to end. However it is possible to conclude that the petrodollar age may be about to end. Very soon we may treat oil as just another energy source and not the ultimate currency of geo-political and geo-economic wars.
Views are those of the authors
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Courtesy: Energy News Monitor | Volume XII; Issue 32
Courtesy: Energy News Monitor | Volume XII; Issue 35