February 3, 2015
Low crude prices are now a fact and likely to remain so for the next few (or more) quarters. This is how long it will take the market to absorb the current supply glut and non-OPEC producers to cut output. The OPEC cartel has already made the decision to keep producing at current levels (at least for the time being) and rely on the market for output reduction, which has further depressed crude prices. The oil price slump will eventually bring about lower output and higher demand, but this will take a while.
An upstream project cycle, from spudding the first well to feeding the first oil into the pipeline, lasts from several months to several years, depending on the technology used. The time needed to bring new oil on tap is the shortest for unconventional deposits. Spud-to-completion times for tight oil in the US average about three months. In contrast, developing an offshore oil deposit takes three to five years in shallow waters (Europe) and an average of eight years in deep waters (Brazil), with some big projects consuming as much as 15 years. The ongoing upstream projects are at different stages and become unprofitable at different oil price levels. The projects in progress are unlikely to be suspended on the prospect of crude prices sagging further, although some of them may face financial hardships due to investment portfolio adjustments made to reflect the new oil market reality. The lion’s share of these projects are expected to survive and expand their production potential over the years to come. Much more at risk are long-term investment projects that have been approved for execution but not yet started. Some of them will be launched on the hope that oil prices will have rebounded when they come on stream. The projects that will bear the heaviest brunt of the oil price slump are investments awaiting the green light (accounted for in estimating global output growth) and development plans in the upstream sector. It is estimated today that in the next two or three years several million barrels a day-worth of output may be lost due to the collapse in oil prices. The first symptoms are expected to be felt in the US in mid-2015. Until then the market will be flooded with more oil as supply reacts with a delay to the current price falls.
Oil prices could be buoyed by a sudden increase in demand, but this is highly unlikely in the next year or two. In its outlook update of January 19th, the International Monetary Fund cut its forecast of the global economic growth for 2015 and 2016 by 0.3pp relative to its September projections. The downward revision has been largely caused by a weaker outlook for emerging and developing market economies, which comes as an effect of China’s economic slowdown (growth forecast reduced to 6.8% and 6.3%, or by 0.3pp and 0.5pp, for 2015 and 2016, respectively) and sanctions that may push Russia into recession (GDP fall of -3.0% in 2015 and -1.0% 2016 relative to a growth of 0.5% and 1.5% in the September projections). The IMF forecast accounts to some extent for the effects of the decline in oil prices from USD 99 per barrel to USD 57 per barrel in 2014 (down 41% year on year) and their recovery to USD 64 (up 13% year on year) in 2015 and 2016.
If the low crude prices are here to stay, what shifts are they going to drive and what are they likely to affect the most, apart from the direct implications for the upstream sector? In addition to the overall impact in the upstream sector, the tumbling oil prices are bound to have certain macroeconomic and geopolitical implications.
The former are related to how global demand and supply are reacting to the price declines. Falling oil prices are shifting income from producers to consumers. In oil importing countries cheaper oil benefits consumers by reducing fuel and energy bills, as lower oil prices mean lower natural gas and coal prices. They also enable businesses to save on the costs of energy and transport and to enjoy the knock-on effects of reduced production costs and lower prices in the economy. Higher disposable incomes left after deducting lower expenses create a powerful stimulus to demand, similar to a tax cut − they boost consumer and investment spending, improve trade balance and fuel GDP growth.
Based on simulations presented in the quoted WEO, the IMF suggests that oil prices falling by 60% relative to the September projections and staying low (which corresponds to the current prices) would add an additional 0.4% to 0.7% to China’s GDP and an additional 0.2% to 0.5% to US GDP in 2016. Cheaper oil means losses to producers and governments in countries producing oil (as well as natural gas and coal). However, the ultimate magnitude of GDP contraction in those countries will depend on whether governments, which take over most of oil revenues, will adjust spending. In countries with huge reserves, like Saudi Arabia, the adjustments can be implemented gradually and will help contain the negative impacts of plunging oil prices on economic activity. But the Russian case demonstrates that countries which cannot afford to accommodate the oil price crash may suffer a deep GDP contraction. However, in the global economy the upside effects will prevail, with the global GDP growth projected at 0.7% to 0.8% in 2015−2016 provided that oil prices remain low in 2015 and 2016.
One of the outcomes of low oil prices is deflation, which can be beneficial to some countries and detrimental to others. In the eurozone the pressure is growing to keep interest rates near zero in the long term and to take unconventional measures that would devalue the euro against other currencies. As the ongoing deleveraging process is a barrier to demand growth, the prospects of lower prices fail to drive consumption, additionally slowing down the deleveraging process itself due to an increase in the ratio of debt to nominal income. In the developing economies falling oil prices also increase the risk of or exacerbate deflation, as is the case in Poland. But for most countries it is the positive sort of deflation, which has the effect of raising disposable incomes and encouraging spending rather than saving.
Yet another effect of the oil price slump is the currencies of emerging market economies and the euro depreciating against the US dollar. The US economy is growing, and the market is expecting interest rates to be raised there, which will cause outflow of capital from the oil and oil derivatives market.
The geopolitical implications stem from the risk of increased tensions over lost income in the countries producing crude oil and other mineral resources. IHS estimates the transfer of income from oil‑exporting countries to oil‑importing countries to be worth between USD 1.5tn to USD 2.0tn (Who will rule the oil market? Daniel Yergin, NYT, 25/01/2015). The OPEC countries need an oil price of over USD 80 per barrel to balance their budgets, with such countries as Iraq, Algieria, Nigeria and Iran needing USD 110-plus per barrel. Russia relies on oil revenues for 45% of its budget. The country’s 2015 budget is based on oil trading for approximately USD 100 per barrel, hence Russia will be forced to tap into its currency reserves (slightly more than USD 70bn) and cut back on planned spending.
In the energy sector a shift is taking place in the relationship between the prices of renewable and nuclear energy and the prices of fossil fuel energy. In the next few years, this shift will mainly touch natural gas and coal prices (already falling on oil price declines), as the share of oil as a fuel in the global energy mix is no more than 5%. Lower-than-expected gas and coal prices projected for the period undermine the profitability of renewable energy projects that are already in progress or have been approved for execution. Over the longer time horizon, the current oil market developments will have no material impact on the growth of the renewable energy sector. The profitability of capex projects will continue to depend on price dynamics within the energy sector, but with the immense amounts of capital invested in the development of renewable energy technologies, we may be in for unprecedented falls in renewable energy prices.