Issue Briefs
Dealing With Depressed Oil Prices
Paolo von Schirach
May 2, 2016
I am not at all surprised to see that the Doha oil talks aimed at finding an agreement among major producers about stabilizing output failed. Saudi Arabia would have liked to freeze production at current levels, which means at the Kingdom’s highest output in modern times, (more than 10 million barrels a day).
No deal with Iran
However, it was obvious that Iran could not possibly have agreed to freeze its own production at current levels. Tehran wants to ramp its production (now at around 3.35 million barrels a day) up to its pre-sanctions peak of about 4.5 million barrels a day. (In fact, Tehran hopes to get to 5.7 million by 2018). And how could anybody have assumed anything else? Of course the now sanctions-free Iranians want to increase their oil production and regain lost market share.
Therefore, no deal in Doha. As a consequence, oil prices while a bit higher, (now hovering around $ 45 a barrel), do not have a chance to go back to pre-2014 levels of $ 100 or above. There is simply too much oil sloshing around.
Oil was good news in America
There was a time in which low prices were really good news in the oil-consuming West. But now it is a mixed bag, especially in the U.S.A. And this has to do with America’s recent and most dramatic oil renaissance.
Indeed, “unconventional oil” exploration and recovery –we are talking about shale oil recovery via “hydraulic fracturing”, commonly knowns as fracking– has been one of the brightest spots in the otherwise timid post 2008 U.S. economic recovery.
Indeed, thanks to fracking, tens of thousands of new, high paying jobs made things a lot better in many oil-producing states, from North Dakota to Texas. (Thanks to fracking, North Dakota went from practically zero oil a decade or so ago to producing about 1 million barrel a day, an astonishing feat).
U.S. oil in recession
But now, dramatically lower prices are bad news for a shale sector composed primarily of small to medium-sized companies, many of them undercapitalized and highly indebted. And here is the problem. Compared to most conventional oil operations, fracking shale is relatively expensive. Most shale operations need oil prices above $ 60 per barrel to stay profitable. With oil well below $ 50 many if not most of them are in trouble.
For small U.S. energy companies planning to recover shale oil it was easy to get bank loans when oil was at $ 100 a barrel or above, and therefore their future profitability was not in question. But now oil is at around $ 40 to $ 45, higher than recent lows of $ 38 or $37, but not high enough.
Therefore the U.S. oil patch, after its remarkable explosion, is now in a recession. Moody’s just downgraded many U.S. energy companies. Tens of thousands of good jobs have already been lost, with more losses to come. This will have a nasty effect in the affected regions, and some negative impact on the overall American economy. (Just to give you an idea of the wide ranging impact of this slump, note that Exxon Mobil, the oil giant with global operations, and therefore way beyond the U.S. shale sector, just lost the AAA credit rating it has held for over 60 years).
Resilience
Things are not awful across the board. In fact, to the surprise of many analysts, the shale oil sector has proven to be much more resilient than what most energy experts had predicted. A combination of aggressive cost cutting and vastly improved production technologies allows at least some shale oil companies to stay profitable even with oil at $ 40. But this is only about some companies. Many will simply not make it.
The other good news is that shale oil production is relatively flexible. It is not too complicated to shut down wells and then start production again in better times, when prices have recovered. Still, idled wells, even though they can be put back into production at some point in the future, do not generate any income. Weak producers have to close down, or go bankrupt. Some may be bought by bigger competitors with deeper pockets.
Sure, at some point this cycle will end. Saudi Arabia cannot afford huge budget deficits forever. Its bizarre policy of keeping production at these high levels, (this way depressing prices), while the Kingdom needs to get into debt in order to fund current government operations (and this includes almost the entire Saudi population of about 32 million getting some money from the Royal Family) will end. But it will take a while. In the meantime, it will be hard for unemployed U.S. oil workers to find other jobs that will pay so well.
Good news for consumers
That said, depressed oil prices, while they hurt an important sector of the U.S. economy, on balance is positive news. Even with its production revolution, America is still a major net oil importer. Lower oil prices translate into a smaller balance of trade deficit. And for the average consumer cheap oil must be good news. Who can complain when finding lower prices at the pump? For tens of millions of American drivers low gasoline prices are equivalent to a tax cut. More money in their pockets.
The future of oil
That said, going forward the real challenge for the U.S. oil sector is not Saudi Arabia flooding the global market. The real challenge will be new, non-oil-based automotive technologies that will kill the oil industry.
Despite its uncertain beginnings, the electric car sooner or later will become economically viable. Elon Musk of Tesla Motors bet everything on making affordable, mid-sized electric vehicles, EVs, a reality. Yes, we know that we are not there yet.
Money losing Tesla in the end may fail. But even if it does, other EV manufacturers will follow. And when someone will hit the sweet spot with easy to recharge, attractive EVs with a good range, that the average consumer can afford, it is good-bye to oil.
Saying good-bye
And that will be a real good-bye. It will not be about temporary sector recessions, or fluctuating prices due to Saudi shenanigans. It will be the end of the oil era.
Here in the U.S. at least someone will be prepared for this gigantic transformation. But economies such as Russia, Venezuela and Saudi Arabia that depend entirely on oil revenues to fund “everything” will be in deep, deep trouble. (Yes, Deputy Crown Prince Mohammed just announced a big plan to eliminate Saudi complete dependence on oil revenue for its economic survival and future prosperity. But this only a plan, however bold. Not even close to reality).
All told, better to be in America. This society, with all its problems, is still capable of promoting disruptive change, while embracing it when it comes.
Paolo von Schirach is President of the Global Policy Institute and an Adjunct Professor at BAU International University. A different version of this article first appeared in the Schirach Report www.SchirachReport.com