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Page added on January 27, 2016

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Who’s afraid of cheap oil?

Who’s afraid of cheap oil? thumbnail

ALONG with bank runs and market crashes, oil shocks have rare power to set monsters loose. Starting with the Arab oil embargo of 1973, people have learnt that sudden surges in the price of oil cause economic havoc. Conversely, when the price slumps because of a glut, as in 1986, it has done the world a power of good. The rule of thumb is that a 10% fall in oil prices boosts growth by 0.1-0.5 percentage points.

In the past 18 months the price has fallen by 75%, from $110 a barrel to below $27. Yet this time the benefits are less certain. Although consumers have gained, producers are suffering grievously. The effects are spilling into financial markets, and could yet depress consumer confidence. Perhaps the benefits of such ultra-cheap oil still outweigh the costs, but markets have fallen so far so fast that even this is no longer clear.

The new economics of oil

The world is drowning in oil. Saudi Arabia is pumping at almost full tilt. It is widely thought that the Saudis want to drive out higher-cost producers from the industry, including some of the fracking firms that have boosted oil output in the United States from 5m barrels a day (b/d) in 2008 to over 9m b/d now. Saudi Arabia will also be prepared to suffer a lot of pain to thwart Iran, its bitter rival, which this week was poised to rejoin oil markets as nuclear sanctions were lifted, with potential output of 3m-4m b/d.

Despite the Saudis’ efforts, however, producers have proved resilient. Many frackers have eked out efficiencies. They hate the idea of plugging their wells only for the wildcatter on the next block to reap the reward when prices rebound. They will not pack up so long as prices cover day-to-day costs, in some cases as low as $15 a barrel (see article). Meanwhile oil stocks in the mostly rich-country OECD in October stood at 267 days’ net imports, almost 50% higher than five years earlier. They will continue to grow, especially if demand slows by more than expected in China and the rest of Asia. Forecasting the oil price is a mug’s game (as the newspaper that once speculated about $5 oil, we speak from experience), but few expect it to start rising before 2017. Today’s price could mark the bottom of the barrel. Some are predicting a trough of as low as $10.

The lower the better, you might say. Look at how cheap oil has boosted importers, from Europe to South Asia. The euro area’s oil-import bill has fallen by 2% of GDP since mid-2014. India has become the world’s fastest-growing large economy.

Yet the latest lurch down is also a source of anxiety. Collapsing revenues could bring political instability to fragile parts of the world, such as Venezuela and the Gulf, and fuel rivalries in the Middle East. Cheap oil has a green lining, as it drags down the global price of natural gas, which crowds out coal, a dirtier fuel. But in the long run, cheap fossil fuels reduce the incentive to act on climate change. Most worrying of all is the corrosive new economics of oil.

In the past cheap oil has buoyed the world economy because consumers spend much more out of one extra dollar in their pocket than producers do. Today that reckoning is less straightforward than it was. American consumers may have been saving more than was expected. Oil producers are tightening their belts, having spent extravagantly when prices were high. After the latest drop in crude prices, Russia announced a 10% cut in public spending (see article). Even Saudi Arabia is slashing its budget to deal with its deficit of 15% of GDP.

Cheap oil also hurts demand in more important ways. When crude was over $100 a barrel it made sense to spend on exploration in out-of-the-way provinces, such as the Arctic, west Africa and deep below the saline rock off the coast of Brazil. As prices have tumbled, so has investment. Projects worth $380 billion have been put on hold. In America spending on fixed assets in the oil industry has fallen by half from its peak. The poison has spread: the purchasing managers’ index for December, of 48.2, registered an accelerating contraction across the whole of American manufacturing. In Brazil the harm to Petrobras, the national oil company, from the oil price has been exacerbated by a corruption scandal that has paralysed the highest echelons of government.

The fall in investment and asset prices is all the more harmful because it is so rapid. As oil collapses against the backdrop of a fragile world economy, it could trigger defaults.

The possible financial spillovers are hard to assess. Much of the $650 billion rise in emerging-market corporate debt since 2007 has been in oil and commodity industries. Oil plays a central role in a clutch of emerging markets prone to trouble. With GDP in Russia falling, the government could well face a budgetary crisis within months. Venezuela, where inflation is above 140%, has declared an economic state of emergency.

Other oil producers are prone to a similar, if milder, cycle of weaker growth, a falling currency, imported inflation and tighter monetary policy. Central banks in Colombia and Mexico raised interest rates in December. Nigeria is rationing dollars in a desperate (probably doomed) effort to boost its currency.

There are strains in rich countries, too. Yields on corporate high-yield bonds have jumped from about 6.5% in mid-2015 to 9.7% today. Investors’ aversion spread quickly from energy firms to all borrowers. With bears stalking equity markets, global indices are plumbing 30-month lows (see article). Central bankers in rich countries worry that persistent low inflation will feed expectations of static or falling prices—in effect, raising real interest rates. Policymakers’ ability to respond is constrained because rates, close to zero, cannot be cut much more.

Make the best of it

The oil-price drop creates vast numbers of winners in India and China. It gives oil-dependent economies like Saudi Arabia and Venezuela an urgent reason to embrace reform. It offers oil importers, like South Korea, a chance to tear up wasteful energy subsidies—or boost inflation and curb deficits by raising taxes. But this oil shock comes as the world economy is still coping with the aftermath of the financial crash. You might think that there could be no better time for a boost. In fact, the world could yet be laid low by an oil monster on the prowl.

economist.com



13 Comments on "Who’s afraid of cheap oil?"

  1. ennui2 on Wed, 27th Jan 2016 12:15 pm 

    Great graph. Everything becomes economically viable at $150 which is still within the range of BAU (IMHO).

  2. Davy on Wed, 27th Jan 2016 12:19 pm 

    US Economy: On a Knife’s Edge

    http://www.acting-man.com/?p=42832

    “We should mention right from the outset that recent data releases – weak as most of them were – are still not confirming an imminent recession with certainty. The situation remains a bit fuzzy: we see a lot of weakness in important data, and considering the overall picture – which includes what is happening globally – we can infer that the likelihood of a significant economic downturn this year is extremely high, but it’s not inevitable. While it is still possible that a recession can be dodged this year, that seems a low probability outcome by now.”

    “The last time a sharp downturn in Texas was clearly triggered by an oil price crash was in 1986. The size and speed of the plunge in crude oil prices at the time was comparable to the recent decline and economic conditions in the region deteriorated significantly. Below is a chart of the Texas leading index published by the Fed. Whenever it has declined to near its current level in the past, a nation-wide recession either soon followed or was already underway – except in 1986:”

    “It appears that many observers believe that the current downturn is ultimately going to result in a similar outcome. There are certainly many parallels to the 1986 event, but we believe it does not necessarily follow that it will remain similarly well contained this time around. We would actually argue that the current downturn has to be more serious and will have more far-reaching effects than the one in 1986.”

    “The recent shale boom was of different magnitude and importance, and has made a major contribution to capex and employment growth in the post GFC recovery. US oil production has more than doubled, returning to levels last seen 40+ years ago. The debt growth associated with the boom has been quite stunning as well. The economy overall has been a lot weaker than in the mid to late 1980s, so it stands to reason that the current boom’s demise will be of greater moment than the oil bust of 1986.”

    “In addition, the still growing problems in the junk bond market are providing indirect evidence that the negative effects of the energy bust are rather unlikely to remain confined to the main oil-producing regions.”

  3. twocats on Wed, 27th Jan 2016 12:35 pm 

    Ennui, i agree with the sentiment of your post. This phrase BAU is thrown around a lot by both doomers and non-doomers alike and it has a lot of user-specific meanings. But whether its BAU or not, if the trend is essentially towards the bottom 50% of global population continuing to use very little resources, and the next 40% using an ever diminishing supply of resources, and the upper 10% (by wealth, not income) continuing to live the dream, then yes, I also believe that state of affairs could continue “for some time” even after peak oil.

  4. JuanP on Wed, 27th Jan 2016 1:36 pm 

    2016 will be a very interesting year for the world and the oil industry. I expect prices to remain around where they are for the year, no lower than $20 and no higher than $60 unless there are some major geopolitical disruptions of the oil industry like a Venezuelan economic collapse or a Saudi civil war, both of which become increasingly inevitable with every passing day.

    This is the time to travel, realize your dreams, have fun, and make ammends. Time is running out, these will be humanity’s last good years.

    Carpe diem, guys and girls! Don’t waste a second, time is precious.

  5. Davy on Wed, 27th Jan 2016 1:50 pm 

    Sure Juan, that is easy for a 1%er to say. Some people have real jobs with families. Few people can live the life of a prick in luxury. I hope you fly home to Naziland for good BTW.

  6. JuanP on Wed, 27th Jan 2016 2:57 pm 

    Board’s fool, we do have internet down there, too, so I could still pester you all I want from down there. You will never get rid of me. Get used to it, fool! LOL! :))

  7. Davy on Wed, 27th Jan 2016 3:03 pm 

    I actually welcome the thought. Nothing gives me more pleased than to bitch slap a prick like you Juan.

  8. JuanP on Wed, 27th Jan 2016 3:10 pm 

    I am totally immune to your foolish rants, fool. You don’t make me angry, you make me laugh a lot, so much I even choke sometimes reading your delusional crap. You are incredibly foolish, delusional, and pathetic. Thank you for that, lying fool, I’ve always thought laughing is good for me.

  9. GregT on Wed, 27th Jan 2016 3:59 pm 

    “the bottom 50% of global population continuing to use very little resources, and the next 40% using an ever diminishing supply of resources, and the upper 10% (by wealth, not income) continuing to live the dream”

    More like the bottom 75% continuing to live life as usual with very little ‘resources’, the next 24% using an ever diminishing supply of those same said ‘resources’, and the upper 1% who currently enjoy 99% of the wealth, finding their dreams turning into complete nightmares.

    The 1% are currently living off of the backs of the labor of the 99%. Their wealth relies on a base of human resources. The only way that the 1% will continue to live in the lap of luxury is through military dictatorship, and/or martial law. This will be extremely difficult to achieve in nations where the general population is well armed.

  10. twocats on Wed, 27th Jan 2016 4:13 pm 

    GregT,

    absolutely, the oxfam report released for the COP21 basically put the carbon emission of the average 1% at 175x times someone in the bottom 50%. Top 10% responsible for 50% of emissions. anyone who thinks population is the biggest issue needs to think seriously about those numbers.

  11. Davy on Wed, 27th Jan 2016 4:31 pm 

    It is both population and consumption at this point. It is more than the carbon emission it is food, water, habitat loss and pollution that each individual human needs. There are not enough 1%ers to matter at this point. If you wipe the planet clean of the rich you would still have another 80MIL to replace them. IMA many of them would just move on in to the open 1%er slots.

    This is now about both population and consumption. Maybe in the early 80’s only consumption could have been argued but not anymore. We are screw on carbon emissions. Now it is about how long can we continue to feed all the people. The rich eat and use water more than the poor but not much. It is all the other carbon baggage that makes the difference. Food and water will soon be the issue not carbon.

  12. GregT on Wed, 27th Jan 2016 4:43 pm 

    “Top 10% responsible for 50% of emissions.”

    Agreed twocats, problem is however, as soon as the current top 10% ( us in the west) were to reduce our emissions, another top 10% ( emerging economies) would rise up to take our place. The sad truth of the matter is, our western lifestyles are not sustainable, and everyone else wants the same lifestyles as what we have. Now if the earth’s population was say 10% of what it is today, then our lifestyles could continue on for quite a bit longer, but they still would not be sustainable.

    So population is a very big part of the problem, but the biggest part of the problem of all, is modern industrial society itself.

  13. Davy on Thu, 28th Jan 2016 3:32 am 

    China is the main driver short term with the global markets and oil. The Chinese currency and economy have such a large impact on the global economy and commodities demand. China is the source of the latest global instability now. The causes go back far and are global. The other problems like Europe’s sovereign debt have not gone away but they are marginally contained. The popping of the status quo bubble is occurring in China and will spread as a contagion. It will likely happen this year.

    This effects oil more than anything else at the moment. If China was humming on all cylinders the current oil surplus would quickly be consumed by China and those countries supporting China with commodities. China’s likely growth rate is much lower than the official rate especially when all the bad debt of the past 20 years is realized. China is imploding and with it the status quo global world.

    “A Whole New Level Of Moral Hazard: China Will Use Public Funds To Cover Venture Capital Losses”

    http://www.zerohedge.com/news/2016-01-27/whole-new-level-moral-hazard-china-will-use-public-funds-cover-any-venture-capital-f

    “It should surprise nobody that when it comes to perpetuating the global central bank “put”, China – which is at daily danger of having its house of trillions in non-performing loan card collapse at any moment – has perfected moral hazard better than any western central banker. However, even the staunchest cynics will be stunned by the latest development out of the Shanghai government where starting next month, venture capital firms which invested in high-tech startups since the beginning of 2015 can apply for government compensation if their investment loses money.”

    “In other words, while until now the government had bailed out corporate bond and bank loan investors, and was actively micromanaging the burst stock bubble (unsuccessfully), it will now enter the venture capital and private equity arena in what may be the grossest misallocation of capital unleashed by China to date.”

    “Of course, what it will encourage instead is another round of massive fraud, and investing in idiotic projects that have zero hope of recovery let alone return, because when one is spending with a full government backstop – like during episodes of QE – the last thing one cares about is trivial concepts like “risk.” There is only the guarantee of return and as Allan Meltzer put it best, “Capitalism without failure is like religion without sin. It doesn’t work.”

    “What it does do is assure that an even greater bust will take place once this particular bubble bursts, however in the process billions in taxpayer funds will be “allocated” to a handful of individuals who will promptly abuse China’s capital controls and end up purchasing luxury apartments in Manhattan.”

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