Awash with oil, the world’s days of $100 per barrel are long gone and unlikely to return soon. For most Americans, the price of gasoline is now about $2 per gallon. The low price is providing considerable economic stimulus here and in the other big oil-consuming nations. But the low oil price is wreaking havoc for the non-diversified, oil-producing nations.
Economic and social tensions are mounting. Oil’s bear market has slashed revenues and the sting of its rapid price decline is stirring the world’s simmering geopolitical pot. Today’s story of oil has become much more than just the story of dissimilar self-interest between the oil-producing and oil-consuming nations.
The oil market is unique. Influenced by far more than supply and demand, oil is one of the most politically affected markets in the world. It is also considered to be one of the most opaque and challenging to follow. That being said, oil’s price decline should not have been surprising as large new supplies continued to be discovered, the global economy stubbornly refused recovery, and the Fed’s easy-money policies began to unwind.
Around the turn of the century, Western economies started experiencing deflationary pressures and globalization went into high-gear. Both changed the world’s political, economic, and social structures. A gradual shift in the oil market began to take shape. Until its precipitous fall starting in 2014, the price of oil seemed to work well for everyone, except possibly for the American consumer.
The U.S. Energy Information Administration estimates the world has more than 1.7 trillion barrels of known oil reserves, with more than half of those found in the Middle East. There is easily enough oil for the world’s next three generations. Huge new finds have been reported in places like Canada, the U.S., Russia and Nigeria. And Iran, with the world’s fourth largest oil reserves, is coming back online after years of being in the geopolitical penalty box for it nuclear aspirations. The world is awash with oil.
But the demand for oil has slowed. Over the last two decades, the Western industrialized nations have been able to taper their oil needs through conservation and alternative energy. The rates of growth for oil demand in Japan, Europe, and the U.S. have fallen dramatically. And with the global economic malaise starting in 2007, further downward pressures on oil demand became that much greater. Recently, even China’s oil demand is reported as off.
Since 2007, known reserves have increased by 30% and production is up 15%. Meanwhile, the consumption of oil is flat, basically rising only with the world’s population growth of 6% during the same stretch of time. As a result of this supply-demand imbalance, the worst possible nightmare for the Saudi King has begun to unfold. Competition and oversupply are causing lower prices and loss of market share.
Saudi wealth became even more threatened when U.S. monetary policy did an about face, first with the ending of quantitative easing (QE) and then with the Fed’s recent interest-rate hike. The money supply has tightened. Consequently, the value of the dollar has risen considerably which is adding to oil’s headaches. The price of oil has been more than halved and frustration inside the Saudi kingdom is climbing.
When oil was priced at $100 per barrel, the world’s oil reserves could generate $170 trillion in future revenues. Now at $30 per barrel, the anticipated revenues have slumped to only $50 trillion. To put the drop of $120 trillion in perspective, consider that the total national wealth of the world for 2015 was $250 trillion. The total GDP: $80 trillion.
The once-higher oil prices allowed oil-producing countries to expand government spending, raise standards of living, and still have enough spare profit to accumulate large foreign currency reserves, mostly in U.S. dollars. The foreign currency reserves helped to prop up producers’ currencies while they inflated their own money supplies. Further, the rapid economic expansion created disincentives for the producers to diversify their economies away from oil. Rather, it guaranteed that these countries would produce even more oil.
The oil-producers’ currency reserves not only helped to expand their domestic economies, but also became a benefit and an eventual curse for the U.S. economy. As oil stayed above $100 per barrel, climbing to a high of $140 in 2007, excess oil profits added to the worldwide savings glut, thus giving the U.S. government and the American homeowner an abundant source of cheap borrowing. Many experts, Alan Greenspan included, agree that excess savings led directly to the credit crises of the Great Recession.
Now, almost a decade later, the large oil-consuming countries cannot afford higher oil prices without the potential for recession, while many oil-producing countries cannot stay solvent if the lower prices persist. Producing countries will be forced to make unsettling changes to confront their deficits. Government budgets have and will continue to be slashed. The foreign currency reserves are evaporating and values of the producers’ currencies are falling, causing the local economies to endure higher-priced imports like food, clothing, medicine, equipment, and technology. Needed capital investment is becoming scarcer and more expensive. And all are increasing the probability of greater social unrest.
The IMF has warned that Middle East countries like Saudi Arabia, Oman and Bahrain will run out of cash within five years if oil prices do not climb above $50 per barrel. Social pressures are now being felt in the Middle East, Venezuela, and Russia as direct reactions to oil’s depressed price.
So if stagnating demand was readily apparent, why was so much new supply created? To many, the potential for danger in oil’s supply and demand structure seemed obvious. But for others, the risks of new oil seemed more than worth it. Only time will tell about the enormous investment in new oil production. Will it turn out to be the next easy-money, moral hazard induced by the Fed’s inflation of the money supply? Another asset bubble ready to burst?
Over the last two decades, most of the world’s governments have been forced to rely on easy-money policies to stimulate their economies. Unfortunately, a terrible side effect of this strategy has been to repeatedly encourage the formation of global asset bubbles. The sheer size and duration of the central banks’ efforts to inflate of the money supply has almost guaranteed their happenings. Recall the world’s excess industrial production capacity and technology bubbles in the 1990s and the banking, credit and housing bubbles in the 2000s. Excess money supply creates moral hazard in the financial markets. It’s useless to argue otherwise.
Touted by policymakers, the hope and promise of economic recovery helped to blunt the very real risk of stagnating oil demand. After the initial shock of the 2008 economic turmoil, oil prices rebounded and consistently trended up. China, another big oil-consumer, seemed to weather the storm of the Great Recession and its oil demand continued growing steadily. Plus, the abundant, low-cost capital provided by the Fed’s easy-money policy would provide a buffer if prices fell. The $100 price of oil seemed well-supported.
The only question seemed to be, if prices did fall, how far could they go? Investors reasoned, $75 or $80 per barrel, maybe, but it can’t stay there for long. China’s demand is too strong. Even at $80 per barrel, the oil companies still make money. $50 per barrel, no way. The global economy is too strong. Investors believed what they wanted to believe, not appreciating that the high price of oil was primarily supported by the Fed’s monetary stimulus and that the world’s economic condition could actually turn for the worse.
As these stories go, the potential for upside gain versus downside risk looked too damn good to pass up. And because it also looked like there was so much room for gain, investors flocked in huge numbers. Picture a mining town in the mid-1800s after the discovery of gold, a bubble knows no better analogies.
And so, capital investment for new oil production went on a binge. Trillions of dollars of equity and debt were invested, with most of it going to projects in North America. Oil production in the U.S. and Canada boomed, good jobs were created, and oil’s new contribution to a recovering U.S. GDP almost seemed like a stroke of good luck. Of course, the investors’ buying of U.S. oil company shares and their junk bonds also went on a binge.
But soon the eventualities of China’s slowdown and the Fed’s halt of QE came. New oil investors were now having nightmares similar to the Saudi King’s. The sobering oil prices cut the value of the oil companies’ shares and junk bonds, throwing both into bear markets.
While U.S. monetary policy has played an undeniable role in oil’s decline, so have U.S. international policies. Terrorism, Iraq, Afghanistan, the Shia-Sunni power struggle, Syria, Libya, the Palestinian homeland – the Middle East’s increasing geopolitical instability was bound to provide necessity for the West, the necessity of finding new oil production outside of Saudi Arabia. The First Gulf War and all of the subsequent turmoil have caused the U.S. to question the wisdom of its Middle East oil dependency and the U.S. has answered by reducing it.
Increasingly, Saudi Arabia is becoming the focal point of the Middle East’s chaos. The World War II alliance between the world’s largest oil-consumer and oil-producer has been broken by the string of terror originating from there. The World Trade Center bombing, the USS Cole, the U.S. Embassy bombings, 9/11, ISIS – all have made Americans weary of dealing with the Saudis.
The table of economic and political dynamics for global deflation is now set. The U.S. economy must face the oil investment bubble, the world’s economic slowdown, the exhaustion of easy-money remedies, escalating geopolitical tensions, and the timing of a naturally-occurring, cyclical slowdown. The oil-producing countries like Saudi Arabia and Russia are facing the same and much worse. Both producers and consumers are limited in what they can do to raise oil prices and the producers can’t afford to restrict supply by cutting production. They need money. Plus, individually, their cuts could not be big enough or last long enough to change oil’s pricing structure significantly. Alternatively, a banding together of oil-producing countries is far-fetched.
Only a coalition of most major oil-producing countries could accomplish a cartel pricing strategy. It would be an alignment of strange bedfellows who would first have to agree to cut production at a time when that can be least afforded, and then agree not to cheat on each other. In today’s increasingly disparate world, such a coalition would be difficult, if not impossible, to organize.
In the slim chance that it did form – a coordinated, non-violent coalition to restrict supply and push up oil prices – Western producers who shut down because oil’s price was too low will be incented to start up again. Those new oil reserves didn’t go away. They were capped, ready to be turned-on when the price of oil rises to a certain level. This is particularly true of the American and Canadian producers. The potential for reboot of operations at higher prices will essentially keep a ceiling on oil’s price for a very long time.
Any discussion on the unlikelihood of production cuts would not be complete without the mention of hedges. Some of the newer oil projects, especially those with higher production costs, did hedge against lower prices. They sold their oil production years forward at fixed prices while prices were higher. Again, this is particularly true of the American and Canadian producers. Their loans demanded it. As such, the hedges make these producers indifferent to price. For them, more production is better, no matter the price. Yet another reason for the oil glut to remain in the short-run.
Although oil’s downward trend may continue (many experts are calling for a price of $20 per barrel), prices at the current level are not sustainable in the long-run. Forget about the oil price needed to balance government budgets. The hard cost to bring a barrel of oil to market, averaged among the world’s largest producers, is reported to be somewhere around $20 per barrel. Although the numbers vary greatly by country and by who is doing the reporting, a general consensus is that the costs per barrel are roughly $10 in the Middle East, $20 in Russia and Venezuela, $30 in Nigeria and Mexico, and $40 in the U.S., Canada, and Brazil. Sooner or later, real economics will have to enter the picture and the selling price of oil must exceed cost plus reasonable profit. Supply and demand must eventually move towards equilibrium to provide for profit incentive.
But how and when this happens is anyone’s guess. The global economic condition through intended and unintended consequences has brought the world to this state. The economics of oil have added to the disorder under which the world operates. There is a global vulnerability now in place. Every player in the world’s oil game is vulnerable to oil’s price, some to higher prices, and some to lower prices. Geopolitical tensions among the world’s nations will continue to form along this fault line. Competition for favorable price and production levels is also likely to become fiercer as oil’s dissimilar incentives and disincentives of each nation continue to become more volatile.
Christopher Petitt is the author of the book, The Crucible of Global War: And the Sequence that is Leading Back to It. It is available for sale at Amazon.com, Barnesandnoble.com and for order at bookstores everywhere.