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The Cost of Cheap Oil

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The world price of oil – Brent Crude – fell below $84 per barrel on October 15.  This was 26% less than the $115 it had reached in June, just four months before.  The rise during the spring had many explanations:  global tensions in Ukraine, the South China Sea and especially the Middle East with the emergence of the Islamic State, plus a capital crunch challenging the health of the U.S. shale fracking boom.  Then suddenly in June, prices started dropping, reaching levels unseen since 2010 (though still high by historical standards – twice that of 10 years ago).

What is going on?  Why does the price of oil matter to financial advisors?  What might these fluctuations mean to the price and supply of oil for the rest of the decade?  Isn’t oil just another commodity?

A primer on oil prices

Oil is unique. There is a tight relationship between energy supplies, especially affordable quantities of oil, and the level of overall economic activity.  Simply put, economies stop growing when their use of energy stops growing. The world moves with oil, and petroleum lubricates the global economy.  It is not simply a natural resource, but the substance that allows all other systems – from food to cities to (unfortunately) war – to exist at the massive scales of today.

For most of the 20th Century, the world’s supply of oil grew steadily, while the price generally declined and remained low1.  This enabled the world’s GDP to expand by a factor of 15, a rate vastly greater than at any time in human history.  The opening years of the 21st century have broken with these trends.  The price of oil is higher (even adjusted for inflation) than it has been since the opening days of the oil age (except for a few brief periods), but global supplies of oil are growing very slowly, if at all, and economic growth is stalling all over the world.

The booming story of American shale oil development and the prospect of “energy independence” had been a defining narrative driving optimism about our economy since 2009.  Many advisors have bought into this story, which depended on enjoying both our new oil and high world energy prices.  The current price collapse could be a threat to that part of our prosperity.

Oil extractors need high prices.  The cost of getting oil out of the ground has been rising at more than 10% per year for over a decade as the new sources of oil moved to deep water, tar sands and shale deposits.  In addition, many nations, especially Russia and those in OPEC, need the revenue from oil to pay their national bills and support the promises made to their people and their militaries.  The break-even price for those producers is approximately $110 per barrel for Brent, and that was the regular price from 2010 to this summer, bouncing around in a tight range.

Oil demand is pretty inflexible over short periods (less than a few years), except when a sharp economic crisis hits, as in 2008.  Most of the time prices are set by the price sellers are willing to accept, as measured by the cost of the marginal barrel.  Ever since the 1870’s, the challenge facing oil producers has been to control and “coordinate” extraction rates to boost prices, but not higher than the buyers could afford.

As one wag put it, on our way to running out of oil, we keep running into oil.

Historically, producers have been pretty successful at this control, from Rockefeller’s Standard Oil monopoly to the global cartel of major companies to the regulation by the Texas Railroad Commission to the emergence of OPEC.  In the first years after 2000, both supply and prices rose sharply to meet global demand, but since about 2005 world crude oil extraction rates have been flat (plus-or-minus 5%) despite even higher prices.

Saudi Arabia has long been considered the “swing producer,” the only potential source of extra supply or reduced production, while everyone else pretty much extracts as much as they can as fast as they can.  When the Saudis raise or lower their output to keep prices stable, others enjoy the benefits of the new prices.  The Saudis have been willing to exercise this responsibility in exchange for security arrangements that go back to FDR, Henry Kissinger, and Jimmy Carter.

What’s changed?

It appears the Saudis are abandoning this role for now, and are instead engaging in a price war.  News reports, always citing “unnamed sources,” suggest the Saudis are willing to let prices drop to the $75-80 range and keep them there for a couple of years to protect their market share.  It is also possible that this is a short-term dare to encourage the U.S. and OPEC nations to share in price-supporting cuts. We will know soon, but the impacts grow the longer the prices remain low.

The best known supply of new oil is the “light tight oil” (LTO) extracted by fracking operations in Texas and North Dakota, which has represented one of the few sources of growth in world oil supplies since 2005.  This oil brings several problems to the markets.  First, a large number of independent companies are involved, and they are not subject to the informal rules of the market that have controlled output for decades.  Instead, the wells are financed with borrowed money, and need rapid production to cover cash flow requirements.  Further, the fracked wells deplete rapidly – on the order of 60% per year – so there is a need for new wells (a “drilling treadmill”) to keep things going.  Finally, the oil is in the wrong place (North Dakota) or of the wrong type (very light) to be economically used by existing refineries on the Gulf coast.  The U.S. has been very proud of this new production for reducing our need for imported oil.  Some LTO may be profitable at prices down to $60, but in June Goldman Sachs estimated a break-even price for this industry at $85 in WTI, which is already higher than the current price (see here and here).

Canadian tar sands oil is also expensive to produce and transport, requiring over $100 per barrel for new projects, according to a recent Canadian study. Without high prices and the Keystone XL pipeline, much of that oil may remain in the ground.

Another problem for the Saudis is the amount of unauthorized oil sloshing around in world markets.  Nigeria reports up to 500,000 barrels per day that is stolen and sold on black markets.  Islamic State finances some of its operations through stolen oil.  Russia and Iran are reported to have barter arrangements designed to skirt economic sanctions.  Kurdistan is selling some oil directly rather than through the Iraqi government.  The situation in Libya changes from week to week.

The impact of low oil prices

While the changes in the global oil market have been at the margins (U.S. LTO amounts to less than 5% of total global volume, and has mostly just offset cuts in Libya and elsewhere), the overall picture could be alarming to the Saudis.  As the U.S. extraction grows, the amount we import from the Middle East declines, so the Saudis need to find new markets for their oil.  Russia wants to sell more oil to China, and the Saudis would like to reduce that threat.

In the United States, there were already efforts to allow the export of U.S. crude oil, even though we still import oil.  As prices decline, more pressure is placed on expensive oil producers, which can be expected to add to the arguments for exporting.   The introduction of U.S. crude exports – we already export finished products like diesel – would bring U.S. prices up to world levels, benefitting producers at the expense of oil users like refineries, manufacturing plants, and the drivers of American cars.  The drumbeat of “American energy abundance” requires higher, not lower, prices.

Further, the Saudis have a number of political scores to settle.  To the extent that the fight against Islamic State is seen by them as part of the larger Sunni-Shia conflict, they cannot be happy to see the U.S. on the same side as the Shiite governments of Iran and Iraq.  Russia has never been an ally of the Saudis, and they are helping Iran, the Saudi’s biggest enemy, avoid Western economic sanctions.  Thus, adding price pressure to Russian oil exports may be one of the main objectives of this price war.  Russians admit that the Saudi-led efforts in 1986 that cut prices below $10 contributed importantly to the collapse of the USSR, and some fear a repeat.  Russia’s budget is based on an average oil price of $100, so the current levels hurt them a lot.

Low prices, while they last, will help the economies of oil importing countries, including Europe, Japan, China, and India.  Many of these countries are teetering on the edge of recession or are facing slower growth rates, so the impact could be significant.  The overall effect in the U.S. may be neutral, hurting oil extraction efforts and the economies of Texas, North Dakota, and Oklahoma, but helping average people who will see cheaper prices for gasoline at the pump and lower shipping costs.  Oil exporters (OPEC and Russia) will face budget pressures, as many of them finance much of their social spending from oil revenue.

If these price cuts are a strategic move by Saudi Arabia, the biggest impact will be several years out.  The major international oil companies – Exxon, Shell, Total, BP, and a few others – are the only firms capable of making the financial and technical investments needed for major efforts such as deepwater projects, drilling in the Arctic and developing the Caspian Sea basin.  However, as costs have risen, they now need to receive $130 per barrel of oil for an adequate return on their money.  They were already cutting back on their capital expenditure budgets with $110 oil.  These new lower prices will discourage them further, and the oil that these projects would be yielding at the end of this decade will not appear on the market.

Similarly, U.S. shale oil efforts need prices well above $80, and many operating companies were already under severe cash flow pressures with $100 oil.  The lenders who have financed these companies over the last five years may be reluctant to continue if prices are low or uncertain.  Watch for a decline in new drilling, made worse by the coming of winter to North Dakota.  The threat to oil production in Canada is even worse, as several firms have delayed or cancelled new operations.  A lot of oil that is expected on the market from 2015 to 2020 may “go missing.”

The large oil service companies like Halliburton, Schlumberger, and Baker Hughes have been thought to be a lower risk way to invest in the oil business, but they will be pressured as capital spending is scaled back by exploration and production firms.

The long-term implications for advisors

Cutting back on future oil extraction might seem a good thing for the fight against climate change, because climate activists have been urging steps to keep fossil fuels in the ground.  It is a double-edged sword, though.

Low fossil-fuel prices will slow investment in wind and solar power.  Electric cars, small cars, and hybrids might be attractive if gasoline is $5 per gallon in the US, but less so at $3.   Relatively cheap oil could also hinder China’s investment in promoting more electrified transportation as a way to deal with its pollution concerns.   An investment that assumes the use of fossil fuels, whether a power plant, a pickup truck, or a parking garage without charging stations, will delay the conversion to alternative energy for the life of that asset.

Confusing the climate challenge could be another Saudi goal.  If the energy conversion process away from fossil fuels is done in time, the global community can possibly avoid the levels of CO2 and other climate-forcing substances that we now know will lead to dangerous temperatures and weather in the future.  On the other hand, if that conversion is done quickly, the main assets underlying the economy and society of Saudi Arabia and many other nations, as well as the owners of many energy companies in the US and elsewhere, may become stranded and worth much less.

Looking ahead, then, it is plausible that the current oil supply glut will lead to a shortage of oil, and higher prices, by the end of this decade, while actions that could have produced useful alternatives may not occur. The current oil price disruption has many possible causes, objectives, and effects, including challenges to the political stability of Russia and many OPEC nations, as well as to the shape of the energy industry over the next decade.

This is only a preview of the magnitude of changes we should look forward to, economically and politically, in the years ahead.  Financial advisors will have to avoid committing their clients too firmly a specific outcome.

  1. A quick note of explanation:  the most common global price for oil is Brent Crude as traded in London.  The most common American price, and the one quoted in the papers and on CNBC, is West Texas Intermediate, or WTI, delivered to Cushing, OK, and traded in New York. Historically, Brent and WTI traded within 1% of each other, but as US and Canadian extraction has grown relative to the rest of the world, WTI now trades at a discount to Brent.  The average price paid by US refineries is closer to Brent than to WTI, so that price is what this paper uses.

Advisor Perspectives

11 Comments on "The Cost of Cheap Oil"

  1. Dave Thompson on Tue, 28th Oct 2014 10:31 am 

    Very level headed out look at our current state of affairs. That is until the end when they start talking about “energy conversion”. On this site most of us know that there is no such thing.

  2. bobinget on Tue, 28th Oct 2014 11:05 am 

    The natural gas industry solved the problem of exceedingly low prices by selling byproduct, higher priced oil.
    There is no way most smaller (under 2 billion cap)
    can survive if both commodities are kept lower.

    Like center right President Obama, domestic oil and gas keep getting pummeled. Both political left and right seem oblivious to what President O or cheap natural gas and even cheaper domestic oil (counting in discovery, lifting, transportation, expense) have done to save an economy that was sliding into failure.

    President Obama didn’t DO anything except step aside
    and allow industry to innovate. Typical center right behavior. Today, greedy, militant extremists, are attempting to camouflage a growing US economy hoping against hope to take full political and economic control. Post election, most expensive propaganda will
    slow to a ‘normal’ FOX News hum.

    By endless critique of the President, H drilling, ‘fracking’, minor issues like abortion, immigration,
    same sex marriage, imagined US plagues, 24/7 cable and talk radio moved the 50 yard line south to where the 20 once was lined. Reasoned debate if you think is still alive, check viewership of PBS Vs FOX or MSNBC.

    Perhaps, when low cities on our coasts flood twice a day like Venice, (twenty years) even Climate Change will be at issue.
    Our Congress voted to remove funding to study climate change. Those responsible retort: “Climate Change needs more study”.

  3. Jerry McManus on Tue, 28th Oct 2014 11:12 am 

    “…the global community can possibly avoid the levels of CO2 and other climate-forcing substances that we now know will lead to dangerous temperatures and weather in the future.”

    Hate to rain on your parade, but that particular horse has already left the barn.

    Those “dangerous temperatures and weather” are no longer in the future, or have they not been following the news for the last few years?

    Some folks are of the opinion that we’ll be lucky to avoid mass extinction at this point. Never mind the unprecedented storms, droughts, floods, forest fires and melting ice caps that are already facts on the ground.

  4. Davy on Tue, 28th Oct 2014 11:19 am 

    Yea Jerry, the cake has been baked. We are just waiting on it to cool a little so the icing can be applied. 4 degrees worth

  5. rockman on Tue, 28th Oct 2014 1:10 pm 

    “Without high oil prices and the Keystone XL pipeline, much of that oil may remain in the ground.” He might have some other decent ideas but this statement alone proves total ignorance about the transport of the oil sands production out of Canada. Tells me he may just be parroting erroneous statements of others to some degree.

    As far as the prices needed to continue developing the oil sands I let others continue to beat that dead horse. But I will offer one simple statistic that can’t be denied: By 2004 oil sands production had reached 1 million bbl/day. During the previous 10 years when that production was developed the inflation adjusted price of oil ranged from a low of $11.91/bbl to a high, in 2014, to $37.66/bbl. I doubt the folks who developed that 1 million bopd rate did so because they wanted to lose money. Granted operations may be a good bit more expensive today but even with the latest price slide oil is currently selling for at least twice what it was when that 2004 rate was being developed. A tad difficult IMHO to argue the oil sands developers have been doing their thing at a loss for the last 20 or so years.

  6. Nony on Wed, 29th Oct 2014 3:52 am 

    Open Keystone and more oil will flow. Transport costs are high.

  7. rockman on Wed, 29th Oct 2014 6:41 am 

    “Open Keystone and more oil will flow.” The Keystone pipeline is flowing oil today with a max capacity of 600,000 bopd.

  8. Nony on Wed, 29th Oct 2014 6:48 am 

    “If completed, the Keystone XL would add 510,000 barrels per day (81,000 m3/d) increasing the total capacity up to 1.1 million barrels per day (170×103 m3/d).[12]”

    500,000 plus 600,000 equals 1.1 million. 🙂

  9. rockman on Wed, 29th Oct 2014 7:19 am 

    “…the Keystone XL would add 510,000 barrels per day”. That production is already being shipped out of Canada by other means. There is currently no oil sands production stranded for lack of transport…every bbl of production is being sold every day. The future? Who knows? But currently there is no need for the border crossing section of KXL. It might move the production cheaper then other means but it hasn’t stopped one bbl from being produced.

  10. Nony on Wed, 29th Oct 2014 7:32 am 

    pipeline cheaper than train, Rock. Raise transport cost and marginal production does not get produced. No? 😉

  11. Nony on Wed, 29th Oct 2014 7:33 am 

    Oh…and how about the danger of trains? How about efficiency? How about your infrastructure president?

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