Friday, January 15, 2016

The Price of Oil - Don't Bet the Farm on it Continuing to Fall!

Today the price of oil dropped below$30 a barrel.  I say "the price of oil" but of course oil comes in many different forms and has many different prices.  But what is usually quoted as "the price oil" is the price of some benchmark grade - usually West Texas light sweet (low sulphur) crude or Brent North Sea crude.  Since the prices usually move in tandem it doesn't really matter what is used as a benchmark, provided of course that it is used consistently.

We now have pundits suggesting that the price might dip to below $20. The drop in price comes with all kinds of consequences.  For us Canadians, it has meant a massive drop in the value of the Canadian dollar and a concomitant rise in everything imported, not least the price of food.  Today the loonie went as low as 68.74 US cents.  Pundits have been rushing to tell us how low it could go - this week several have been saying that it could be at 59 cents by year's end.  

This is all treated as something beyond human control, like bad weather, forest fires or earthquakes.  To some extent the low oil price is due to a glut in production - the US is now producing more than Saudi Arabia, thanks to the relatively new technology of fracking.  Also the drop in price today was attributed in part to the prospect of Iran getting back to producing for the world market.  Of course on the other side of the ledger is reduced demand, or perhaps just the fear of it, with China's phenomenal growth expected to be trimmed by a percentage point or two.

But I think there is much more to this than simply the intersection of supply and demand.  For decades since its creation in the mid-70s OPEC (Organization of Petroleum Exporting Countries) has successfully restricted supply to maintain a price considered best for its members.  By far the most powerful member of OPEC is Saudi Arabia, and it was a Saudi decision, announced in June, 2014, to not cut production, that lead on to further drops in price.  

Why did the Saudis do this?  There have been many explanations offered.   The most widely believed seems to be that it is an attempt to drive high cost US shale producers out of the market.  Other explanations have invoked attempts to support the US in its vendetta against Russia, and to make life as difficult as possible for the Saudis' perennial rival, Shiite Iran, who, now sanctions are about to be lifted, plan to re-enter the world oil market.

I don't know enough of the technical details of the oil market, to be sure of this, but I suspect that single-handedly by cutting production, Saudi Arabia could restore the price of oil to a level much higher than it is today - perhaps not back up to $100 a barrel, but perhaps to $50 or $60 where it was when the Saudis announced their 2014 decision.   If this is so then perhaps the Cassandras and Chicken Littles who are warning of $20 a barrel or lower should reconsider.

Why do I say this?  Well for one thing the low price is hurting the Saudis as well as other producers.  They have run serious budget deficits for the last couple of years, not only due to the reduction in revenue, but also due to their wasteful, ill-advised and criminal war in Yemen.  This war seems to be something of a quagmire at present and the costs in weaponry, and mercenary soldiers, who do most the fighting for the Saudis, could grow even higher than today.   The IMF has made warnings about the non-sustainability of recent Saudi budgets, and has warned that they are seriously draining their reserves.  Recently the government brought in some restraint measures, including raising the domestic price of fuel (at a time when the world oil price has dropped precipitously!).  

In the past the Saudi Royal Family has been able to essentially buy off internal dissent by offering jobs, scholarships etc. to dissatisfied parties, especially young people.  But while they face the prospect of more discontent at home, due to their austerity measures, they are constrained in how much they can spend to buy off the opposition. Also there is reportedly serious discontent within the Royal Family, over the direction in which the country is being lead.   Prince Mohammed bin Salman, aged 30, is the Defence Minister and is reportedly behind the rash war in Yemen.  One can easily imagine that there are others in the Royal Family who feel that something has to be done to remove this hothead.  A palace coup is a serious possibility. What this would mean for their oil policy is hard to predict, but it is quite possible that it would lead to a volte-face.

Even without a coup, it is possible that the Saudis will back down on their policy.  There seems to be little sign of it working so far, and it seems to be hurting them more than their rivals in the US.

Beyond the internal machinations of the Saudi government, there is another reason why oil prices might suddenly rise.  This is the possibility of war or serious political instability in the Gulf and wider Middle East.  The Saudis seem to be doing everything that they can to goad Iran into military action - the New Year's execution of the leading Shiite cleric, the breaking off of diplomatic relations etc.  And only this week the possibility of hostilities between the US and Iran raised its head, with the incursion of two US navy vessels into Iranian waters, with the usual lies and contradictions emanating from the US side. Fortunately diplomacy quickly diffused the situation, but one can only imagine, with horror, how someone like Ted Cruz would have reacted if he had been in charge.  Remember there are many (especially NeoCon Israeli supporters) in the US power establishment, who would love an excuse to torpedo the Iran nuclear deal.   I think it is something in the order half of the world's oil supplies pass through the Straits of Hormuz.  In the event of hostilities with Iran this would be shut off immediately.  The price of oil would shoot up faster than it has descended.

Another locus of hostilities could well be Libya.  It has been  predicted ( that there are plans underway for a US/British/French/Italian invasion of Libya to oust the growing influence of IS in that country. According to the article, the Western powers are waiting for the finalization of the mooted deal between two rival governments.  A new supposedly unified government would then invite the western powers to intervene on its behalf.  Hillary Clinton and all of the Republican candidates (except Ron Paul, and surprisingly perhaps Donald Trump) would jump at the chance for more overseas US adventures.  What effect this would have on the wider Middle East, and on the price of oil is hard to predict.  It is easier to predict that it would end up achieving pretty much the opposite of what was intended.

I hate to say this, but from the point of view of the price of oil, and perhaps the world economy in the short term, the best thing that could happen is a war in the Persian Gulf.  I don't want it to occur  but unfortunately there are many who would.   

There are many reasons why the decline in the world price of oil could be reversed.  Extrapolation is easy - hence the predictions of the continued drop in price.  Predicting future political outcomes is much harder, and I believe that the current low price is, in large part, the consequence of political decisions, which can easily be reversed or thwarted.  So don't bet the farm on a continued slide in the price of oil and in the value of the loonie!


  1. The price of oil has headed toward the marginal cost of its production in the Middle East several times over the past 100 years. The difference this time is the availability of the US shale oil. Saudi have said they will no longer act as a swing producer to maintain quotas in OPEC but I expect the real motive is to drive US shale oil producers to the wall. I think that will occur at about $65Us per barrel which is my forecast for oil prices intermediate term. There could be a temporary overshoot of this price if too many firms move out of the shale business.

    1. So you too, Harry, don't believe in a continued fall. How low do you guess it will go before recovery? Your forecast is based on economic factors. But there are a lot of political uncertainties in the mix.

  2. I don't know. Depends how tough the Saudis want to make and the reentry of Iranian supplies. If you recall the paper on oil well valuation, the marginal costs of the Saudis are very, very low.