This article is originally published in the Daily Mirror Business of 3rd June 2015, as part of the ‘Smart Future’ series. It departs from the usual Sri Lanka focus, to discuss the global oil market dynamics, as the Organisation of Petroleum Exporting Countries (OPEC) meet at the end of this week, to decide whether to maintain the status quo with regard to oil production and prices, or to change course.
Two years ago when Robert Wescott – a former economic advisor to US President Bill Clinton – told a group of us at an economics forum that in a few years the price of oil will drop sharply to undermine alternative unconventional sources, few in the room believed him. It was an era of 100-dollar oil, production of unconventional sources was still muted, and we simply couldn’t see that changes. But exactly two years later we are seeing exactly that playing out. The OPEC in general, and Saudi Arabia in particular, are battling to retain and grow their market share of the global oil market, alongside the growth in unconventional oil production the US and elsewhere. Will this be the defining story of the rest of this decade? This week’s ‘Smart Future’ column departs from its usual Sri Lanka focus to take a wider view on the dynamics of global oil.
High Oil Prices and Recession Risk
Before the oil price decline, the global economy was experiencing high oil prices that were placing immense pressure on the recovery of the global economic out of the prolonged recession. At the I.S.E.O. Institute event in Italy 2013, I asked Wescott about the role of high oil prices in fuelling or prolonging recessions. He said, “100 dollar oil is the dominant macro story of the last seven years”, and “high oil prices were the most important cause of the global recession”. He argued that, “Oil was at 147 dollars well before the Lehman crash and financial meltdown; the world economy was already in recession due to high oil prices. The financial crisis tipped it over”. Going by some of the evidence on the link between high oil prices and business cycles, it would seem that the global economy was lucky this time. The sharp drop in oil prices came at a time when the global economy was going through a tricky transition – recovery in the US, but severe weakness in Europe and tepid performance in China, and Japan. Although the relationship is imperfect, there is research showing that spiking global oil prices and global recessions (as determined by the US NBER) are closely linked.
Oil Prices and the Macroeconomy
There are many channels through which, theoretically, high oil prices affect the macroeconomy of an oil-importing country. Demand effects suggest that high oil prices reduce real income growth and more spending for fuel means less income for other forms of consumption. On the supply side, rising energy costs eat into business profits if they cannot be passed on, and energy-intensive sectors, like transportation (particularly aviation), may cut activity and layoff workers. There are also policy effects of high oil. Although central bankers may emphasize core inflation more than headline inflation, higher inflation may spark fears of a price-wage spiral and cause monetary tightening. This could weaken investment spending, both by households and firms. There are also knock-on effects on business confidence and markets. Higher oil prices hurt both consumer and investor confidence – as equity prices decline, household wealth effects turn negative. Conversely, in a low oil price environment, much these effects are observed in the opposite.
Current Oil Price Scenario
The global oil market can be characterized as a partial monopoly market. Nobody controls the whole market, but OPEC can be considered as a partial monopolist, controlling a significant share. The economic theory to understand the behavior of the OPEC oil cartel was developed more than half a century ago by Heinrich von Stackelberg and it appears that the arguments he put forward for OPEC are playing out today. Von Stackelberg argued that if OPEC consistently overcharged for oil, it may 1) cause a global recession and hurt demand for your oil, 2) you may lose market share; 3) you may encourage technical innovation to replace your oil. These features began to emerge over the past decade, and last year we saw OPEC responding with causing sharp price reductions in an attempt to maintain market share and drive out other sources of oil. Oil prices have nearly halved in the past 12 months. From US$ 110 per barrel a year ago, Brent is now hovering around US$ 65 per barrel, after reaching a trough of around US$ 55 in March. WTI (NYMEX) has seen even sharper declines. In May, OPEC ramped up production to a two-and-a-half year high of 31.22 million barrels of oil per day. The continued high global supply of oil is likely to continue to keep prices at a lower price equilibrium than seen recently.
Rise of Unconventional Sources in the US
Conventional oil usually comes from on-shore or offshore sources, where the reserves are relatively smaller but the extraction costs are much lower than unconventional sources that are much deeper down and require unconventional technology to extract. Unconventional sources include shale gas and shale/tight oil as well as oil or tar sands (mainly in Canada). For many years, drilling for oil and gas in shale rocks had been prohibitively expensive. But technological advances in the US over the last decade made the “fracking” (hydraulic fracturing) method more feasible, and high global oil prices made shale extraction more economically feasible. The production of shale oil (or tight oil) in the US rose from zero in 1990 to 3 million barrels per day last year – it is set to rise to 7 million by 2030. The production of shale gas (dry natural gas) in the US rose from less than 3 trillion cubic feet in 1990 to 15 trillion cubic feet in 2014 – it is set to rise to 20 trillion by 2030. Driven mostly by the shale oil industry, total US domestic crude oil production is now at levels not seen in 30-40 years. But the global oil price decline has hit US shale hard.
Unconventional Oil Production in Adjustment Phase
US shale oil producers are victims of their own success. The decline in global oil prices was, is in large part, due to the US shale revolution itself and the supply glut it created. Shale oil extraction has high marginal costs – driven mainly by the expensive fracking technology itself (and the capital expenditure costs) as well as the intensive water required for fracking. Maintaining productivity in fracking facilities requires reinvestment every few years, and with global oil prices so low, the return on these investments come in to question. Data from the US energy industry show that the number of shale rigs has begun to drop, as unproductive and cost-inefficient facilities go out of business. The total oil rig count in the US is down by around 42% since the beginning of this year and around 46% from its highs mid last year. This falling rig count has been mainly driven by the fall in rigs drilling unconventional hydrocarbons. It is clear that there will certainly be a lot of adjustment in the US domestic oil production industry. Production rigs that were productive and economically feasible in a 100-dollar oil era will certainly not be the same in the 60 or 70-dollar oil era. As renowned economist Prof Razeen Sally said, responding to a question I posed to him at a forum on the global economy a couple of weeks ago, the US shale industry is likely to see “accelerated consolidation” to stay competitive, and technology in shale extraction will continue to improve to meet the cost-efficiency pressures in a lower oil price era. There are also arguments that the rigs now coming off line are those that were already declining in production and that the robust rigs are still operating. It might also be mistaken for traditional oil producers like OPEC to assume that driving down US shale producers alone would be sufficient to beat the rise of unconventional sources. Unconventional oil sources are available not only in the US. In fact, Russia is reported to have more of the global share of recoverable shale – 22% compared to the US’s 17%. China too has around 9%. So, some of the largest consumers of oil globally are also likely to continue to have unconventional sources of oil available for extraction domestically, putting further downward pressure on global oil prices.
Implications for Sri Lanka
There are major shifts taking place in global oil markets, and as an importer and ‘price-taker’ of oil, it is important that Sri Lanka keeps a close eye on the evolving dynamics of the global oil market. Sri Lanka has greatly benefitted from the decline in global oil prices, and it came at a convenient time for the new government, which came into power promising sharp fuel price cuts. Ideally, what could have happened is that the policy and price space that comes with a low oil price environment would have given Sri Lanka the impetus to undertake critical energy policy reforms. The IMF has been strongly advocating for countries to take advantage of this opportunity to reform costly subsidies on fuel and electricity, and to redirect those resources to growth-enhancing investments such as education, health and infrastructure. But as the low oil prices came amidst a heated election cycle, we didn’t see this opportunity used, and moving forward it is unlikely that structural adjustments in energy policy would take place now. If oil prices continue this lower price equilibrium – forecast to be between 65-80 dollars a barrel for at least the rest of this decade, the government elected in the next parliamentary election should take full advantage of the space this offers and undertake reforms to energy pricing and subsidies. These would be a lot more politically difficult in a high oil price environment.
This is the 14th article in the ‘Smart Future’ column that advances ideas on competitiveness, innovation, and economic reforms. It draws from insights gained from the Nobel Laureates Summer Programme of the Istituto di Studi Economici e per l’Occupazione (I.S.E.O.), Italy.