by Jim Welsh with David Martin and Jim O'Donnell , Forward Markets
Whenever a commodity as important as oil moves by more than 40% in a short period of time, there are likely to be repercussions no one can foretell with any certainty. What we can say with certainty is there will be surprises in 2015 and some of them won't be good.
The winners are easy to identify since the costs of living and doing business have just fallen materially for any consumer or business that uses oil or gasoline. This should be a net positive for global growth even after accounting for the reduction in capital investment in energy that will weigh on growth. For countries dependent on the sale of oil, however, the decline in revenue will capsize fiscal budgets, potentially forcing a reduction in energy subsidies, which consequently might incite riots or even a revolution in some countries.
Until producers agree to cut production, oil is likely to remain under $60 a barrel and potentially even fall to under $40 a barrel in the short run. In this game of chicken, those with the deepest pockets can afford to apply pressure on marginal producers until they are forced to cut production or get out of the game. Saudi Arabia had $737 billion in reserves as of August since in recent years it chose to save a portion of its annual oil revenues. This puts Saudi Arabia in a strong position relative to a number of other OPEC (Organization of the Petroleum Exporting Countries) members since it can finance current domestic government spending for three years.
Since June, oil prices have fallen from $107 a barrel to $54. Make no mistake: a significant increase in U.S. oil production is driving the decline. Technology has made it possible to extract more oil from shale rock, drill deeper in the Gulf of Mexico and tap more oil deposits through horizontal drilling techniques. The result of all this innovation is that domestic oil production is 8.9 million barrels a day, up from 4.7 million barrels a day in 2008. Although oil produced in the U.S., by law, cannot be exported, it has lowered our demand for imports from other countries like Nigeria, which has provided the U.S. oil for 41 years. While not long ago the U.S. was importing one million barrels of oil a day from Nigeria, in July 2014 it didn't import a single barrel. With no U.S. demand for Nigerian oil, Nigeria was forced to sell its oil to China, India and Indonesia, taking market share from other producers. The increase in global oil supplies initially forced more competition and price discounting to protect market share between oil producers. Gradually, the downward pressure on the price of oil increased and turned into a cascade when Saudi Arabia and fellow OPEC members couldn't agree to cut production.
This is a textbook example of how the law of supply and demand impacts prices. As production of oil increased in the U.S. over the past five years, the growth in supply incrementally rose faster than the growth in global demand. The price of oil will fall until a new equilibrium between supply and demand can be established. This may take longer than some expect since countries and companies dependent on oil revenue are likely to increase production to replace some of the lost revenue caused by the decline in the price of oil. In the U.S., companies that borrowed money to jump into the fracking business late have a higher cost of production than companies that were at the forefront of the fracking revolution. Those companies that borrowed money will likely choose to increase production to service their debt. This creates a paradox where one company increases production so it can avoid default, which leads to more supply and lower oil prices, which then pushes more companies to the brink and to the same decision. Ironically, the first company's decision to increase production winds up making it even more difficult for it to survive after other companies are forced to make the same decision. Another reason U.S. supply may increase in the short run is that halfway finished wells are likely to be completed rather than abandoned. As the finished wells come on stream, they will add to the supply of oil.
If oil remains below $60 a barrel for a prolonged period, the risk of negative surprises is likely to increase. Governments overly dependent on oil revenue to support government spending could be especially vulnerable. According to a recent analysis by Deutsche Bank, the “breakeven” levels per barrel of oil for the following countries are: Iran and Bahrain: over $130; Ecuador, Venezuela,Algeria and Nigeria: around $120; Libya: $110; Russia: $100; Angola and Saudi Arabia: $93; Oman, Kuwait, Qatar and U.A.E.: around $70. All of these countries will be tempted to increase production in an effort to generate more revenue, which could lead to a decline below $40 a barrel. Although most of these countries may have to confront some level of disequilibrium, the two countries that pose the greatest geopolitical risk are Iran and Russia.
In recent years, Iran has threatened to close the Strait of Hormuz in response to U.S. pressure on Iran's nuclear program. In January2013, Iran's ambassador to Iraq said Iran would have no qualms about closing the Strait of Hormuz; If Iran faced a “problem,” it would be within its rights to “react and defend itself.”1 Oil below $130 a barrel for an extended period is a serious problem for Iran and there is no certainty in how its leaders may respond to this problem. More than 20% of the global supply of oil flows through the Strait of Hormuz, so even a temporary disruption could cause a large rally in oil prices.
The last decade has been good for the average Russian citizen. Putin exerts almost total control over the news flow in Russia and the typical Russian citizen believes Putin's decision to take over Crimea and his support for the separatists in Ukraine is merely a response to aggression from the West, the U.S. in particular. They believe the Malaysian passenger jet was shot down not by the separatists but by NATO because that's what they have been told by their media and government. The Russian media says that NATO shot down the plane so it could blame the separatists and Russia for supplying the weapons. Russia's gross domestic product (GDP) may fall by more than 4% in 2015, but Putin's approval rating is over 70%. As the recession begins to affect the average Russian citizen next year,support for Putin will likely decline. When Putin's popularity wanes,the risk of Putin doing something “patriotic” will increase. In 1998, Russia defaulted on its loans, which led to a shakeout in global financial markets. We doubt he would take that action now, but he could threaten to stop making interest payments on the $670 billion Russia owes to western banks and investors. Since the West imposed the sanctions and engineered the plunge in oil prices,according to Russian media, not paying interest on loans to western banks would seem like the right payback to the average Russian citizen and cause Putin's approval rating to rise.
There are 19 countries in the Middle East and North Africa that rely heavily on energy price subsidies to provide a social safety net and a form of income distribution for their citizens. According to the International Monetary Fund, subsidies provided by these countries totaled $237 billion in 2011 (the most recent data available). The average cost of one of these subsidies represents 22% of government revenue and 8.6% of GDP. In contrast, food subsidies amounted to just 0.7% of GDP on average in 2011. Oil represents about half of total energy subsidies, with the balance coming from electricity and natural gas. Subsidies benefit households directly through lower prices for energy used for cooking, heating, lighting and personal vehicles. These subsidies are highly inequitable,however, as they disproportionately go to those with incomes in the top half, yet any reduction has a far greater impact on the poor,who manage to survive on a few dollars of income a day. Large swings in the price of oil also subject the fiscal budgets of these countries to periods of big surpluses and deficits. Those countries that experience large fiscal and current account deficits when oil prices fall significantly are then vulnerable to capital outflows,which can cause a country's currency to fall and result in higher domestic inflation.
Countries dealing with a depreciating currency caused by large fiscal and current account deficits face a number of difficult choices. One option is to raise interest rates to stabilize their currency, as Russia recently did from 10.5% to 17.0%. Even if an interest rate hike is successful in stabilizing a country's currency in a free fall, large increases in interest rates often tip the domestic economy into recession, as Russia will experience in 2015. In order to lessen the strains from a fiscal and current account deficit, a country with a large energy subsidy may be forced to reduce that subsidy. Since energy consumes a much larger portion of income in poor countries, a lower subsidy can put an unbearable strain on the poor managing to survive on a few dollars a day. If a country lowers the subsidy too much, it risks riots and, in extreme cases, a possible revolution.
China and India will benefit from lower oil prices. China is the world's second largest net importer of oil, and each $1 decline saves China about $2 billion. If oil prices remain under $60 a barrel throughout 2015, China's bill for imported oil could be $80 to $100 billion lower. According to the World Bank, a dollar of farm output takes four to five times as much energy to produce as a dollar of manufactured goods. Since most of the world's farmers are poor,cheaper oil is a plus for poor countries. More than 30% of those who live on less than $1.25 a day live in India. Oil accounts for more than 3% of India's imports, so lower oil prices will improve its trade balance and lower India's rate of inflation. In early 2013, inflation was over 10%, but it has already fallen to 4.38% in November and is likely to fall more. Since India provides subsidies for energy, lower oil prices will also help it lower its budget deficit from the current level of 4.5% of GDP.
