What an $80 barrel of oil means to the world

Prices of the black stuff have fallen by 30 per cent in five months as global supply outstrips demand. Ben Chu answers the key questions, including which nations are set to gain or lose out

Ben Chu
Wednesday 26 November 2014 02:58

Why is the price of oil falling?

The essential answer is that supply of the black stuff, which powers vast swathes of the global economy, is outstripping demand. America, the world’s largest economy, has dramatically stepped up its domestic production levels of oil in recent years. The United States pumped out 8.6 million barrels per day in the month of August, up from just 5.4 million per day as recently as in 2010. According to the US Energy Information Administration (EIA), the country’s output is now at its highest level since 1986. America alone now accounts for 10 per cent of global production.

The reason for this surge is that heavy investment by private energy firms in new extraction techniques is paying off. Horizontal drilling and hydraulic fracturing (more commonly known as “fracking”) for oil in shale rock formations have transformed the industry in America. States such as North Dakota, Texas and Pennsylvania are booming as a consequence.

At the same time some other significant oil producers elsewhere in the world, such as Libya and Iraq, have also brought back considerable new production in recent years as domestic, political and military turmoil has abated.

Canada, which is exploiting its vast Alberta “tar sands”, has also increased production.

Simultaneously, global demand for oil has stumbled. China, the world’s second largest consumer of oil, is on course for its weakest year of GDP growth since 1990 this year. The eurozone is teetering on the brink of another recession. Slowing activity growth is dampening their thirst for oil.

The impact of this supply glut and demand weakness on the global oil price has been dramatic. In the middle of June, oil was trading at $115 per barrel. Now, each one is selling for around $80.

That’s a 30 per cent decline in just five months. Oil has not been cheaper in four years, when the global economy was still emerging from the Great Recession.

Will the oil price stay down?

There would seem to be more legs in the American production boom. The EIA expects output to increase again next year on the back of improvements in drilling productivity and the construction of more rigs. Some analysts think prices could remain in the $75 to $80 range for some time to come. Some are saying it could yet dip as low as $60 a barrel.

But the International Energy Agency (IEA) has predicted that US production of “tight oil” (the relatively hard to reach deposits locked in shale rocks) will plateau over the next decade and fall thereafter. That would exert upward pressure on prices.

Meanwhile, on the demand side, the still relatively poor nations of Asia and Africa are forecast, notwithstanding wobbles such as China’s this year, to continue growing rapidly over the coming decades. They will suck in more oil as they continue to industrialise. The IEA estimates that global demand will increase from 90 million barrels a day now to 104 million barrels a day by 2040. That implies the price of oil will increase over the medium to long term.

Yet making predictions for the oil price is immensely difficult. New technologies can have dramatic and rapid impacts on supply, as we have seen in the US. Technological developments also profoundly affect demand. The fuel economy of American cars and trucks has improved in recent years, dampening the need for oil in the world’s biggest consumer.

And even over the very short term, analysts and traders struggle to forecast oil prices. For instance, as recently as August the futures market was pricing oil today at over $100 a barrel.

Which countries benefit from cheaper oil?

Some developing world governments are already benefiting. The Indian government of Narendra Modi has used the opportunity offered by the sharp drop in the oil price to eliminate state fuel subsidies. Getting rid of those subsidies would have been much more painful if fuel prices were not already falling.

The Indonesian government of President Joko Widodo did the same last week, cancelling subsidies on retail petrol and diesel. Getting rid of these distorting subsidies should help their economies develop in a more balanced way. It will also encourage them to burn fewer fossil fuels.

China, which spends 2.5 per cent of its GDP on net oil imports, is another major beneficiary. Cheaper oil could help the Communist Party-ruled state grow, boosting the profitability of its firms.

Some economists expect a global economic stimulus from cheap oil. It is estimated that a $30 drop in the oil price transfers $400bn from oil exports to importers over a year. That should, in theory, free up resources in household budgets for more spending, which should, in turn, boost growth.

But which nations lose out?

The big producers of oil are generally worse off, especially those countries whose exports are dominated by oil and which don’t have a diversified economy to fall back on.

Russia is a prime example. It is the world’s second largest oil producer after Saudi Arabia. Energy accounts for 70 per cent of all its exports and more than half its budget revenue comes from oil and gas.

The Russian economy is now in freefall. This is partly due to the sanctions imposed on Moscow by the West over the Ukraine issue. But the tanking oil price is playing a major role too. President Putin has admitted the drop in the oil price is potentially “catastrophic” for the country. Venezuela, South America’s biggest oil producer, is in serious trouble too. Oil accounts for 95 per cent of its exports and it needs oil to sell at well over $100 a barrel to fund its spending commitments. Nigeria, whose oil exports to the US have dwindled to nothing, has also taken a hit.

The Middle East exporters are also suffering. But not all are suffering equally. Saudi Arabia, which has massive accumulated cash reserves, can cope with prices at the current level. And the United Arab Emirates and Kuwait could reportedly balance their budgets with oil as low as $73 and $53 a barrel respectively.

Consumers in Europe, which is not a net oil producer, are likely to benefit. But the low price is also creating a headache for eurozone policymakers. The 18 countries of the single currency are grappling with low inflation. The consumer price index rose by just 0.4 per cent year-on-year in October, well below the European Central Bank’s official 2 per cent target. Low inflation is making it harder for governments on the Continent to deal with their public debt piles.

Low oil prices are also something of a double-edged sword for the UK. Prices below $80 make further development of the remaining reserves of North Sea oil unviable. If those reserves aren’t tapped there will be a cost in terms of jobs. Our country’s sprawling balance of payments deficit could get even worse too.

But will we at least get cheaper petrol?

We’ve certainly been reaping the benefits so far. The average national cost of a litre of petrol fell to 127p last month, according to the AA. That’s the lowest price since January 2011. Diesel is down to 131p per litre. A price war between supermarkets which operate 15 per cent of the 9,000 or so pumping stations around the country has helped push down prices too. Americans, who already pay relatively little for fuel, are also benefiting. Fuel fell to $3 per gallon this month in the US, down 70 cents since June.

Will low oil prices keep interest rates down?

The Bank of England thinks there remains “slack” in the economy, meaning unused and wasted resources.

In order to use up this slack as quickly as possible, the Bank has signalled its willingness to keep interest rates at rock bottom levels of 0.5 per cent well into next year – in order to help steer the economy through a rather hairy environment.

One thing that could prompt the Bank to put up interest rates earlier is a jump in consumer price inflation. But inflation has been driven close to five-year lows (1.3 per cent in October), helped by low oil prices. If oil prices continue to decline that will push down on the cost of living still further and make the Bank of England more relaxed over low interest rates.

Will the Opec cartel fight back?

The Organisation of the Petroleum Exporting Countries, a cartel of major pro- ducers, certainly has form on this front. In the 1970s, OPEC cut back on supply, contributing to an inflationary surge across the developed world. Some have speculated it might try to push up prices again at its next scheduled meeting tomorrow.

Russia and Venezuela reportedly discussed ways of supporting prices last week. But so far Saudi Arabia and Iraq have resisted calls to reduce output. Indeed, they have actually cut export prices to the US.

There are signs of division in the cartel. One minister in Tehran recently accused Saudi Arabia (a regional rival) of deliberately keeping prices low in order to harm the Iranian economy. Analysts speculate that the Saudis might be calculating that a healthy global economy will ultimately be better for oil demand in the longer term – and that lower oil prices in the short-term will help to achieve this.

In any case, Opec’s influence in the market has declined since the 1970s, when it accounted for about 50 per cent of global oil supply. The cartel’s production is now just over 40 per cent.

Another potent signal of Opec’s diminished importance in the market is the fact that of the world’s five largest oil producers only one – Saudi Arabia – is an Opec member.

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