By Anubhav gupta

Edited by Madhavi Roy, Senior Editor, The Indian Economist

James Buchan, the famous Financial Times Correspondent said, ‘A century ago, petroleum – what we call oil – was just an obscure commodity; today it is almost as vital to human existence as water.’ Oil, and in particular changes in oil prices, has caused governments to fall, go bankrupt, and go to war. A country’s political and economic clout is closely intertwined with the amount of oil it produces or consumes. So, as oil prices have fallen to a 2-year low with seemingly no bottom in sight, the world has been watching with bated breath.

 Recently, investment bank Goldman Sachs slashed its forecast for both West Texas Intermediate (known as WTI) and Brent crude — the two most common types of oil used and sold in North America and Europe. Goldman Sachs has said that WTI, the North American benchmark, will sell for $75 a barrel in the first three months of 2015. Brent, the international benchmark, meanwhile, will change hands at $85 a barrel. These forecasts follow the highs of WTI and Brent ($107 and $115) in June, after which they have been in a free fall.

In fact, this situation is the result of a simple supply and demand mismatch, though with extremely complex consequences.

Increased supply

The primary reason behind the falling oil prices is a global supply glut.

United States

The United States has decided to crash the party, and in some style. This month, it’s expected that the U.S. will pump out more crude oil than Saudi Arabia does — the first time that’s been the case since the early 1970s. American production has almost doubled in the past five years, thanks to the new drilling technologies—horizontal drilling to position wells which run through layers of petroleum-rich rock, and hydraulic fracturing to break up dense geological formations, as well as new pipeline routes to move crude to the refineries and petrochemical complexes that line the coasts of Texas and Louisiana. This oil and shale boom has returned the US to its erstwhile position as the world’s largest producer and threatens to eliminate the power of the OPEC cartel to fix oil prices.

OPEC

However, OPEC (Organization of the Petroleum Exporting Countries), which produces 40% of the world’s oil, is wise to this threat. Historically, OPEC, led by Saudi Arabia (OPEC’s largest member), has countered falling prices by cutting production quotas in order to drive it right back up. This time, no such action has been taken. It is widely believed in oil circles that at the OPEC meeting next month, Saudi Arabia will pressurize other countries in maintaining the status quo. The Saudis are ready to suffer short-term losses with a long-term view of driving the US ‘frackers’ out of business. Middle Eastern countries, apart from having extensive oil reserves in the ground, also have massive foreign currency reserves, accumulated during the ‘good old days’ of soaring oil prices, and are thus well insulated from the falling prices. US shale fracking, on the other hand, is more expensive than Saudi oil production and the break-even price for a barrel is higher. Ironically, the same drillers and refiners who helped increase the American output could be driven out of the business by a price war.

Other producers

Libya has returned to producing oil following a period of virtually zero production. Concerns over ISIS disrupting oil supplies from Iraq and Syria have not materialized. Similarly, Russia’s controversial involvement in Ukraine has not disrupted its supplies to China and Western Europe.

Falling demand

At the same time, sluggish economic growth has led to decreased demand.

The International Monetary Fund cut its global growth forecasts for this year and 2015 earlier this month, warning that the world economy might never achieve the pace of expansion achieved before the financial crisis. Recent economic figures from the US have been weak, and growth in China, the second biggest oil consumer after the US, has fallen to a five-year low. European recovery has stalled, with weak economic info coming in from Germany, France and the UK. The increase in the US’s domestic production and inflow of Canadian oil into the US, has led to a sharp fall in the oil imported by the US. Countries like Nigeria and Libya are unable to find buyers among the US refineries.

Impact

Oil prices are expected to stay in the $75-$85 bracket (TWI) for at least a year. Also, a revolution in oil pricing is imminent.

The Saudis’ strategy to undercut US ‘frackers’ is not going to work as 98% of US oil has a break-even price below $80 (its own oil’s break-even price is $93). Even with its huge forex reserves it cannot afford to keep the price of oil lower than the present value for a long period. And the Iranians, Nigerians, Venezuelans and Russians, who depend on oil revenues for at least half of their national budgets, will be screaming for higher prices before they face riots in the streets. As the largest producer and consumer of oil in the world, the US is expected to have a major say in oil prices and may eventually be liberated from its compulsion to intervene repeatedly in Middle Eastern disputes.

For countries that are net importers of oil like India (oil accounts for about a third of India’s imports), the falling prices are a huge boon. Cheaper energy moderates inflation, which has already fallen from over 10% in early 2013 to 6.5%, bringing it within the central bank’s informal target range. This should lead to lower interest rates, boosting investment. Cheaper oil also cuts India’s budget deficit, now at 4.5% of GDP, by reducing fuel and fertilizer subsidies. The government controls the price of diesel and compensates sellers for their losses. But, for the first time in years, sellers are making a profit. On October 19th, Narendra Modi, India’s prime minister, said he would finally end diesel subsidies, free diesel prices and raise natural-gas prices.

All in all, the falling oil prices are expected to boost the global GDP by 0.5% and help to reign in budget deficits of countries like India and China, while providing consumers with cheaper fuel. Something to cheer then, eh?


Anubhav Gupta is a first-year student of Economics at St. Stephen’s College, University of Delhi. As a future investment banker, he strives to explore and learn about every nook and cranny of the financial markets. He is an avid reader with a particular interest in philosophical and historical fiction. He devotes the rest of his time to running and globetrotting.

Posted by The Indian Economist | For the Curious Mind