Energy Academic Group Seminar
February 20, 2014
The Causes and Consequences of
The Oil Price Decline
Dr. Robert Looney, NSA
Overview I
• November 2014 decision by OPEC not to cut production
reflects a profound shift in the world oil market.
• The demand for oil by China and other emerging
economies is no longer the dominant factor.
• Instead, the surge in U.S. oil production, bolstered by
additional new supply from Canada is decisive
• This surge is on a scale that most oil exporters had not
anticipated.
• Normally, economists would consider the oil price drop a
positive development, but this time there are doubts.
• Impacts will occur unevenly across oil exporters and
importers making generalizations difficult.
• One of the greatest impacts may be the first phase of new
economics of oil paradigm – and a realignment in global
economic power
2
Overview II
3
Overview III
• The oil price drop was largely unforeseen by experts
• As late as October, 2014 a key concern of many analysts
was the risk of an oil price spike caused by geopolitical
tensions
• Rather than geopolitical tensions in Ukraine and Iraq
causing a price spike, causality is from economics to
politics
• The plunge in oil prices now threatens Russia’s public finances, and
ability to destabilize the region
• In the Middle East the funds to finance vicious conflicts in Iraq and
Syria face greater pressures which promise to stretch all sides. Iran
may be compelled to sign a nuclear agreement.
• In the Caribbean and Latin America, Venezuela will loose much of its
ability to influence policy and events through its Petrocaribe program
of oil subsidies to neighboring countries
• In Nigeria the government will be hard pressed to fight Boko Haram
Outline
5
Causes of the Oil Price Drop I
Causes of the sharp drop
• For any commodity, underlying demand and supply
conditions determine the long run trend in prices
• Short term movements in market sentiment and
expectations also exert influence
• Prices may drop rapidly due to surprises in the news -even before actual changes occur
• In 2014 relevant events included
• Geopolitical conflicts in some oil producing regions
• OPEC announcements, and
• The appreciation of the U.S. dollar
• Long term developments in supply and demand have
also played important roles in driving the recent decline
in oil prices
6
Causes of the Oil Price Drop II
Trends in supply and demand
• Recent developments in global oil markets have occurred
against a long term trend of
• Greater than anticipated supply, and
• Less than anticipated demand
• Since 2011 US shale oil production has persistently
surprised on the upside
• Expectations of global demand have been revised
downwards on several occasions during the period as
economic growth disappointed.
• Global growth in 2015 is expected to remain much weaker
than during the 2003-08 period when oil prices jumped
• The oil-intensity of global GDP has almost halved since
the 1970s -- result of increasing efficiency and declining
oil intensity of energy consumption
7
Causes of the Oil Price Drop III
8
Causes of the Oil Price Drop IV
9
Causes of the Oil Price Drop V
IEA Forecast of World Oil Demand
10
Causes of the Oil Price Drop VI
Change in OPEC Objectives
• Saudi Arabia has traditionally acted as the cartel’s swing
producer
• Using its spare capacity to either increase or reduce
OPEC’s oil supply, and stabilize price within a desired
band
• The OPEC decision in November, 2014 to maintain
production level of 30mb/d signaled a significant change
in cartel’s policy objectives
• From targeting an oil price band to maintaining market share
• No doubt, changed position reflects concern over
increased competition from shale
11
Causes of the Oil Price Drop VII
Receding geopolitical concerns about supply disruptions
• In second half of 2014 became apparent that supply
disruptions from conflict in Middle East did not
materialize as expected
• In Libya despite internal conflict production recovered by
0.5 million barrels a day (about 0.5% of global production)
in the third quarter of 2014
• In Iraq, as advance of ISIS stalled, became apparent that
oil output could be maintained.
• In addition, the sanctions and counter sanctions imposed
on Russia have had little effect on oil and natural gas
markets thus far
12
Causes of the Oil Price Drop VIII
U.S. dollar appreciation
• In the second half of 2014 the U.S dollar appreciated by
10% against major currencies in trade-weighted terms
• A U.S. dollar appreciation tends to increase the price of
oil in non-U.S. currencies
• The decline in demand and thus oil price often large
• Empirical estimates very greatly on impact on oil price
• The high estimates suggest a 10 percent appreciation is
associated with a decline of about 10 percent in the oil price
• Low estimates suggest a 3% or less
13
Causes of the Oil Price Drop IX
• Speculation
• Beyond traditional demand and supply factors some have
suggested “financialization” of oil and other commodities
as a factor leading to the price decline
• Leads to greater likelihood of speculation in commodity
markets
• Little hard evidence that this is the case in the recent
price drop
• Latest IEA report indicates that oil inventories reached
their highest level in two years
• Suggests expectations were of a price increase not
decrease
• For the longer term – several trends important
14
Long Term Drivers of Oil Price Decline I
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Long Term Drivers of Oil Price Decline II
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Winners and Losers Overview
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Winners: U.S. I
• Falling oil prices may slow down the shale revolution but
are still good news for the U.S. economy
• Cash saved by consumers on gasoline will provide about
$75 billion to spend on other goods – about 0.7% of total
US consumption
• Some analysts predict a fall in oil investment, but
Goldman Sachs pegs it at no more than 0.1% of GDP
• Lower oil prices have made economists more confident
about the outlook for 2015
• HSBC has raised its growth forecast from 2.6% to 2.8%
• Cheaper oil will weigh on already low inflation, but the
Federal Reserve is ready to act if deflation looks like a
possibility
• Impact mixed across states – some winners, some losers.
• Some banks increasingly vulnerable
18
Winners: U.S. II
19
Winners: China
• China benefits less than might be expected from falling
prices despite being the world’s largest oil importer
• Partly because the heavy reliance on coal means most of
the economy is exposed to oil prices through the
transport sector.
• Diesel and petrol prices set by the state stop closely
tracking oil prices at around $80 a barrel.
• Good news for state-owned oil refiners CNPC and
Sinopec, but less so for businesses and drivers.
• Several of China’s banks are also heavily exposed to
major oil exporters including Venezuela, leaving China
vulnerable when falling prices hit those country’s ability
to repay loans
20
Winners: Japan
• Japan is a clear winner from falling crude prices
• In the last fiscal year to March 2014 the country spent
$236bn on fuels, of which more than 90 percent was
linked to oil.
• For every 10% drop in the price of a barrel represents
about $21.6bn
• A 30% drop in oil hands back about as much cash as was
raised by the government this year when it increased the
consumption tax by 3%.
• In effect a narrowing in the country’s budget deficit has
been totally paid for from aboard.
• However lower oil is a mixed blessing for the Bank of
Japan – could make it more difficult to achieve its 2%
target for inflation -- country may slip again into
defilation.
21
Winners: Eurozone I
• The EU imports 88 percent of its oil, but the picture is
mixed
• At first glace lower energy prices very positive:
• Come as welcome relief to European industry struggling to retain
competitiveness with the US
• In terms of consumer prices cheaper is a mini-stimulus package
– still problems:
• Still problems:
• Problem for the ECB – inflation already low and veering towards
deflation
• Many countries have looked to inflation to alleviate the debt
burden that is restraining spending power
• Oil’s freefall has also battered European stocks, particularly
London’s energy-heavy FTSE
• Some banks carrying oil-related loans also in trouble
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Winners: Eurozone II
• Other problems:
• Major projects in Europe such as Britain's North Sea will be put
on hold
• For Germany overall positive
• While country is shifting towards renewable power petroleum still
makes up about a third of energy consumption
• Business confidence has been boosted by cheap oil and the
decline of the Euro
• German GDP is expected to grow by 1.5% in 2015 of which a
quarter percentage point is attributable to the drop in oil prices
• Oil price decline expected to boost overall economic activity
through an increase in domestic purchasing power
23
Winners: UK
• With rapidly declining oil extraction in the North Sea,
most of the UK is a modest winner from oil price drop.
• For Aberdeen the oil capital of Scotland and the UK,
outlook is bleak since the city specializes in deep sea oil
extraction technologies which are increasingly
uneconomic with cheaper oil
• But Aberdeen’s loss is the rest of the UK’s gain
• Lower fuel prices have pulled inflation down to 1 percent
and have
• Eased pressures on household and company budgets
• Raided confidence
• Improved the growth prospects for 2015
• For the public finances the outlook is less rosy as the oil
industry is heavily taxed
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Losers Overview
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Losers: Nigeria
• Nigeria’s emergence as Africa’s largest economy due
mostly to rapid growth in services
• However, country still depends on oil for more than 60%
of state revenues and 90% of export earnings
• Compounding the problem is the escalating Islamist
insurgency in parts of the North.
• Oil production is down – averaging well below its 2.4mb/d
capacity due to massive theft and a lack of investment
following five years of legislative paralysis over reforms
for the industry – the result.
• Foreign portfolio investors have taken flight
• The government has slashed spending for 2015
• The stock market was down 23 percent in 2014 and
• The country’s currency has had a massive devaluation
26
Losers: Iran
• Iran holds the world’s fourth largest reserves
• Country already struggling with impact of Western
sanctions before oil began to fall
• Government is seeking to rebalance the economy to
reduce its dependence on oil
• From around 50% to closer to one third – would be the lowest in
decades
• With no prospect of oil prices going up in the near future
there is added pressure to strike a nuclear deal before the
June deadline
• US banking sanctions have cost Iran half its oil revenues.
• An agreement could potentially allow Iran to sell more crude and
have access to about $100bn of foreign exchange reserves
which it has been barred from accessing
• Failure could lead to a further shrinking of the economy and
social unrest
27
Losers: Saudi Arabia
• Fiscal buffers are in place to offset the impact of any
potential domestic deficit.
• Still, country will be among the country’s most affected
by lower oil prices
• Oil receipts average 85% of exports and 90% of fiscal
revenues
• At $60 a barrel the country would have a fiscal deficit of
around 14% of GDP in 2015
• Its vast foreign exchange reserves of $750bn will offset
much of negative effects of lower oil prices
• Although denying it, likely pullback in spending on social
programs which had increased substantially following
unrest during the Arab spring
• Even so, Saudi Arabia has used leading position in OPEC
to resist calls for a production cut.
28
Losers: Venezuela
• Venezuela is estimated to lose $700m for every dollar
drop in the price of oil – oil 96% of export revenues
• Even before the 2014 drop in price there was speculation
the country might have a default.
• These fears have intensified with the economy shrinking
3% in 2014
• Population is struggling with shortages of basic goods
and inflation is running at more than 63%
• Estimates are the country needs a price of above $130 to
balance its budget
• To cover some of the losses the country needs to
increase production to between 2.4mb/d and 2.8mb/d but
even under the best circumstances that would take years
to come on stream.
• PetroCaribe??
29
Losers: Russia
• For the Russian economy the drop in the price of oil and
the Ukraine crisis have created the perfect storm.
• Oil and gas account for 75% of the country’s exports and
• More than half of its budget revenues
• Its currency moves closely with the oil markets – falling
significantly in 2014 due also to geopolitical risks
• As a result, the $600bn burden that Russian banks and
companies owe foreign creditors is getting heavier by the
day
• Debt servicing complicated due to western sanctions
baring most borrowers from refinancing this debt with US
or European banks
• With Russia reliant on imports for almost everything
except commodities, inflation is expected to rise to above
30
10%
Losers: Mexico
• Mexico is opening up its oil and gas sector to private
investment after nearly 80 years of state control
• Stands to see investment squeezed as a consequence of the oil
price decline
• Companies vying for the chance to drill $100m wells say they
may scale back their investment
• Silver lining
• The country imports about half its gasoline so lower prices are a
bonus.
• Crude accounts for less than 15% of Mexico’s exports
• Country has a hedging program which it says will shield it from
the impact of crude price declines in 2015
• A $20-a-barrel fall in the price of Mexico’s oil in 2015 would add
up to less than 1% of GDP
• Not insignificant, but fiscally manageable – Moody’s
31
Losers: Canada
• The Canadian energy sector accounts for 23% of exports
and approximately one-third of capital spending
• Many Canadian oil sands projects have operating costs
in the 40-60 dollar range and will remain profitable if
prices stay in that range
• Production expected to grow by 5-6% a year in the near
term: most imminent production was planned years ago
• Current prices will only have an impact on production growth
later in the decade
• Growth in oil sands has typically been more closely tied to
demand rather than price
• Lower prices will reduce Canadian GDP by 0.1% and
growth down by 0.20-0.25% from 2.4% before price fall
• Government revenues will decline by C$500 million in
2014 and C$2.5bn annually from 2015-19 if WTI hovers
around 81$
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Global Economy I
• As a rule a rule, $US10/b decline in oil prices transfers
roughly 0.5% of world GDP from net exporters to net
importers
• As former have a higher propensity to save, the net effect
is to increase global demand.
• Extent of boost depends on
• Whether the oil price decline is driven by supply or demand –
supply will have the greater impact. Current situation supply
shock
• How much of the oil dividend accruing to oil importers is spent –
given on going de-leveraging from the 2008-09 crisis, less likely
to be spent than in the past
• How much the price of oil changed to end-users accounted for
by taxes—greater share – less impact
33
Global Economy II
• Extent of boost depends on (contd.)
• Whether governments that subsidize fuel take
opportunity offered by lower prices to cut subsidies and
raise taxes – blunt impact of lower prices
• Exchange rate movements – recent decline in oil price
coincided with dollar rally – decline in oil prices in euro
and Japanese yen less marked in dollar terms – many
emerging currencies have fallen sharply against the $
• By the IMF rule, oil price drop should increase global
GDP by 0.4%
• Taking into account factors noted here the figure may be
closer to 0.25% -- 0.30%
• The U.S. likely to be the biggest winner.
34
Future Oil Prices
• Many analysts feel movements in future oil prices are
likely to be influenced by several key factors:
•
•
•
•
•
Future supply/demand conditions
Keystone Pipeline
Impact of lower oil prices on alternative fuels
OPEC strength/objectives
A cutting of energy subsidies
• As a general rule, lower oil prices today by reducing
investment result in higher prices in the future
• Key question – how has shale modified this relationship?
35
Future Supply Conditions I
How persistent is the supply shift likely to be?
• Depends on two factors
• First is whether OPEC and in particular Saudi Arabia will be
willing to cut production in the future
• This depends in part on the motives behind the change in its
strategy and the relative importance of geopolitical and
economic factors in that decision.
• One hypothesis is that Saudi Arabia has found it too
costly in the face of steady increases in non-OPEC
supply to be the swing producer and maintain a high
price
• If so, and unless the pain of lower revenues leads other OPEC
producers and Russia to agree to share cuts in the future –
strategy unlikely to change in the near term.
36
Future Supply Conditions II
• A related hypothesis is that it may be an attempt by
OPEC to reduce profits, investment, and eventually
supply by non-OPEC suppliers
• Some of whom face much higher costs of extraction than the
main OPEC producers
• The Second Factor is how investment and in turn oil
production will respond to low oil prices.
• Exploration and production budgets for 2015 face
significant curtailment
• Major projects in high-cost oil basins will be cancelled or
postponed
• However the time lag between investment and production means
that additions to supply will continue to come on stream for some
time
• Many projects are simply too far ahead to be stopped
37
Future Supply Conditions IV
• For unconventional oil such as shale (which now
accounts for 4 million out of a world supply of 93 million
barrels a day):
• The break even prices – the price at which it becomes
worthwhile to extract in the U.S. are typically around $60 per
barrel
• However a new analysis based on individual well data finds that
80% of new tight-oil production in 2015 would be economical
between $50 and $69 a barrel
• Companies will continue to improve technology and drive costs
down.
• Still with prices near or below $60 a barrel, U.S.
companies are looking hard at their investment plans –
where and how much to cut or postpone.
• But it will take time for these decisions to affect supply
• U.S. output will continue to rise in 2015
38
Future Supply Conditions V
• Break-Even Prices for U.S. Shale basins
39
Keystone Pipeline I
• Heavy crude carry from Alberta comes from one of the
highest cost sources of energy in the world
• With low crude prices, the $8bn project may seem
questionable
• However when prices are low, transport costs provided
by a pipeline as opposed to rail become even more
important to the industry
• Some potential projects have been shelved,
• For projects underway, stopping development makes no
sense
• Once upfront money has been spent
• mining projects need oil prices of $45 to cover running costs
• while in place projects need just $20
40
Keystone Pipeline II
• For new projects what matters is not today’s oil price but
what is expected over the longer term.
• Forward oil prices in the futures market have also fallen
but much less sharply than the near term
• US crude for delivery at the end of 2020 has dropped
roughly 25 percent to about $67 a barrel
• If prices do stay around that level in the coming years
they would be exactly in the range where Keystone would
be most significant
• State Department analysis suggested
• If U.S. oil prices were above $75 enough projects would be
profitable for output to grow
• Even if it had to be sent to U.S. refineries by more expensive rail
– extra cost is about $8 p/b
41
Keystone Pipeline III
• With prices below $65 few new projects would make
sense even if the pipeline were available
• However if the price were is the $65-$75 range higher
transport costs could have a substantial impact on oil
sands production levels
• Climate groups argue now that in an era of cheap oil
Keystone XL pipeline could make or break oil sands
production
• For these groups it is critically important that the project
should be stopped
• For the oil industry, it equally raises the need for it to go
ahead
42
Clean Energy I
• Will falling oil prices hurt clean energy?
• Several reasons why the clean energy industry will have
only limited impact.
• First, while, all commodities in the energy industry are to
an extent intertwined
• Oil and renewable energy do not directly compete with each
other.
• Oil is primarily used to produce transportation fuels, while
renewable energy is used to generate electricity
• IEA – diesel and other petroleum based fuels constitute
only 5% of global power generation today compared to
25% in 1973
• Therefore fluctuations in oil prices will have little impact
on renewable energy sources like solar, wind and
biomass in advanced economies
43
Clean Energy II
• Second, over the long run there is an important price
difference between
• energy derived from technology based sources like solar and
• wind and commodity based sources like coal and oil
• Over the long run productivity increases in the
technology based fuels results in a decline in their costs
as innovation proceeds
• Studies in Europe show that the cost of energy from
utility-scale solar and wind farms even without subsidies
has become widely competition with electricity produced
from conventional fuels including nuclear
• The cost of utility-scale solar fell 80% and wind energy
fell 80% in the last five years
• Last year when global clean energy increased by 16% to
$310 billion even as oil prices declined
44
•
OPEC I
• An effective cartel requires three things:
• Discipline
• A dominant market position, and
• Barriers to entry
• OPEC lacks all three
• Its members cheat on quotas,
• It supplies only 30% of the world’s oil – too little to exercise
control and
• New producers abound
• OPEC more follows the a dominant firm model than a
cartel
• Saudi Arabia its most influential member could have sent the
price up simply by deciding to pump less
• The Kingdom has savings of $900 billion
45
OPEC II
• But Saudi Arabia can also weather a low price
• Its production costs are $5-$6 a barrel – the lowest in the
world
• History suggests most of the gains from any cut in its
output would go to other producers who would sell their
oil for more while increasing their market share
• Saudi Arabia did try this tactic in the early 1980s cutting
its output drastically
• Result -- higher prices but also a boom in investment and
then production in places like Britain and Norway
• Trying to save OPEC with such tactics could be even
more dangerous now
• Cheap oil has its consolations for Saudi Arabia
• Russia and Iran two countries which the Saudis have differences
are hurt much more
46
Energy Subsidies
• Many exporting countries are planning to cut back on
energy subsidies. This would make more oil available for
export putting downward pressure on oil prices
47
Likely Future Prices I
• Likely developments regarding OPEC strength,
alternative energy supplies, the Keystone pipeline, and
the cutting of energy subsidies all impacting on future
prices suggest little upwards pressure.
• This is what is suggested by futures markets which now
show an expected recovery of prices into 2016
• However, uncertainty comes not only from supply, but
also geopolitical and demand factors
• Geopolitical Factors
• geopolitical tensions in Libya, Iraq, Ukraine and Russia should
not be underestimated
• Demand Factors
• High uncertainty about global economic activity, especially in the
Eurozone and China, and thus the derived demand for oil
• Not much optimism now for rapid global expansion.
48
Likely Future Prices II
• Short Run Oil Price Movements
• Currently the oil market is massively oversupplied
• Unless OPEC acts as a swing supplier a glutted market is
highly unlikely to be avoided given the lags involved in
curbing production.
• Some supply curtailment is already evident in early 2015
especially in U.S. shale
• However there will be a substantial inventory overhang
through most of 2015
• Demand for oil should increase somewhat given lower
prices and by early 2016 demand and supply should once
again be in balance.
49
Likely Future Prices III
• Persistent excel supply
50
Future Prices IV
• U.S. Rig Utilization Declining
51
Future Prices V
• Several factors might modify this outlook
• Key downside risk
• instability in Eurozone results in many countries falling into
recession
• Key upside risks are
• an acceleration in demand particularly with China topping up its
strategic reserves, or
• A supply disruption sparked by geopolitical frictions,
• Baring these oil prices should reach approximately $78 in
2016 and continue to firm up further in the ensuing years.
52
Future Prices VI
53
U.S. Energy Security I
Implications for U.S. energy security
• We define energy security as the ability of households,
businesses and government/military to effectively
manage disruptions in energy supply.
• Traditionally low prices have been looked on as reducing
energy security because they
• Undermine incentives for investments in energy expansion and
efficiency
• May remove sources of revenue that deter investors from
upgrading or expanding energy infrastructure that that could
enhance the reliability of the energy system.
• Countering these two tendencies are
• The prospect of rising prices beginning in the first part of 2016
and,
• Developments in global markets that may have fundamentally
altered the economics of oil
54
Energy Security II
How will U.S. energy security be affected?
• With the good prospect of markets firming up again in
2016, whatever loss in energy security has occurred
because of the oil price decline, should be quickly
reversed.
• In addition the period of low prices are unlikely to have
an adverse effect on alternative renewable energy
supplies
• The period of low oil prices has demonstrated the
weakness of OPEC.
• That organization unlikely to play a major role in the future in
constraining energy supplies
55
U.S. Energy Security III
• Most importantly the oil price drop demonstrated that
there is a new economics of oil
• In the past, new supplies of oil had come from large
expensive fields with a long lag between price increases
and subsequent follow on investment
• Today, a shale-oil well can be drilled in as little as a week
and at a fraction of the cost of conventional oil
• Process is a little like manufacturing drinks – whenever
the world is thirsty, you crank up the bottling plant.
• Shale development should reduce volatility in oil markets
while providing the world and the U.S. with diversified
sources of oil – both enhancing energy security
56
U.S. Energy Security IV
• In addition there appears to be underway a shift in
conventional oil production
• away from unstable higher cost sources --- Venezuela, Russia,
Nigeria, and Iran
• toward more secure lower cost locations -- specifically the GCC
• The GCC is determined to maintain market share and to
do this they are expanding productive capacity and will
likely hold the price lower than in the past to accomplish
this – in effect replacing OPEC
• Their output will come at the expense of higher cost
countries
• Saudi Arabia has sustainable oil production capacity of
12 million b/d
• Kuwait is investing in sustainable capacity of 4 million
b/d and Abu Dhabi going for 3.5 mill b/d
57
U.S. Energy Security V
• By 2020 the six GCC states could be in the position to
produce 21 million b/d
• Why Should the GCC countries change their strategy?
• Markets since 1973/74 have allowed the GCC OPEC
states to meet global demand at times of supply
interruptions elsewhere and to adjust exports to meet
OPEC price targets
• Supply risks remain but they are much lower. Consuming
countries have
• Increased strategic reserves
• Diversified away from potentially unreliable oil and gas sources
• Boosted domestic energy production and
• Promoted renewables
58
U.S. Energy Security VI
• There are good reasons for the GCC to radically raise
production and exports
• We are entering an era where production efficiency rather
than control of reserves will be decisive
• Neither Saudi Arabia nor OPEC will be able to prevent a
secular and structural decline in energy prices
• If the GCC wants to maintain its oil and gas income, it will
have to increase hydrocarbon exports
• Lower prices in turn will weaken three U.S. adversaries
Russia, Iran and Venezuela
59
U.S. Energy Security VII
• If Saudi Arabia and the GCC lift production as much as
possible US-GCC combined production will exceed 30
million b/d by 2020.
• This is a figure higher than OPEC’s 2014 production and
would be equivalent to about 30% of forecast world
demand for that year.
• It would be enough to ensure the GCC working with the
US for a generation and more will be able to shape the
structure and direction of global energy
• These oil price trends and associated developments
should considerably enhance U.S. energy security.
60
Questions
• Questions?
61