Sultans of Swing- Oil prices and the global Economy

“Oil is almost like Money.” – A crazed oil Tycoon

Oil is the world’s biggest and most pervasive business, the greatest of the great industries that arose in the last decades of the nineteenth century. And in the current era, oil is still seen as central to security, prosperity, and the very nature of civilization. The story of oil is characterized by the rise of capitalism and modern day business. Oil has become the basis of the great postwar suburbanization movement that transformed both the contemporary landscape and our modern day life. We have become, in the words of anthropologists, a “hydrocarbon society”. And as in the past, oil has been a massive generator of wealth for individuals, companies, and entire nations. In the words of one tycoon, “oil is almost like money”.  Despite the disruption and onslaught of technology industries, there are two petroleum companies in the top 20 Fortune 500 Companies, and until some reliable alternative source of energy is found, the global economy will be addicted to oil.

As for any commodity, the basic price dynamics of oil are determined by the demand and supply of oil. The OPEC countries are the largest suppliers of crude oil today, and collectively have over 81% of the proven crude oil reserves of the world.  As in the past, the OPEC countries have been instrumental in setting the global prices of oil, as they have been the major suppliers. However, the majority of refinery capacities are located in North America (21%) and in Asia and the Pacific (32%), where there is a fast addition in refinery capacities.  The existence of refineries in these regions implies a demand for the final products of oil, and list of the top 5 global importers of crude oil gives us a picture of the key demand regions: China: $134.3 billion (16.7% of global crude oil imports), United States: $132.6 billion (16.5%), India: $72.3 billion (9%), South Korea: $55.1 billion (6.9%), and Japan: $45 billion (5.6%). There is a positive relation between the growth of the global economy and oil demand. The improving dynamic of the global economy has been confirmed recently and is reflected in the current global economic growth forecast of 3.4% for 2016 and 3.2% for 2017 by IMF. Moreover, after the historic OPEC/non-OPEC declaration of cooperation in November, 2016 oil producers may get more impetus, leading to more investments. As per OPEC, world oil demand growth in 2016 is expected to increase by 1.32 million barrels per day, because of better-than-expected consumption in OECD Europe and Asia Pacific. The demand for oil is pervasive, and has its use across a plethora of industries ranging from specialty chemicals to construction. However, the bulk volumes are generated by the transportation and petrochemicals industries. According to OPEC,  road transportation is anticipated to continue to be the driving factor for oil demand growth in 2017, primarily as a result of anticipated high vehicle sales in the US, Europe, China and India.
Thirdly, the expanding petrochemical sectors in US and China are projected to lend support to petrochemical feedstock. The fortunes of several industries are impacted by the rise and fall of oil prices. For example, after the steep drops in oil prices, industries which need oil as an input like aviation, have seen their margins and profits expand. But, industries like Exploration and Production (E&P) have been severely impacted, resulting in lower spending on capital expenditures in the oil sector. Refiners, have however, seen an improvement in their profit margins because of the drop in the oil prices. Moreover, the global shipping industry is heavily dependent on the oil trade. A drop in oil prices have sent freight rates down globally and this has led to an adverse impact on the shipbuilding industry. World oil supply in 2017 fell year-on-year, by 0.46 million barrel per day because of lower OPEC and non-OPEC oil supply.

Oil prices globally have seen a sharp drop in prices from 2014. Brent crude prices have dropped from a peak of $111/barrel in June 2014, to a low of $27.67/barrel. The reason for the drop is manifold, with a drop in the growth of China’s insatiable appetite for commodities being one of the prime reasons. Amid this slowdown in the demand, the 2014 OPEC meeting which saw Saudi Arabia, the largest producing member of the cartel, signal no cut in production levels, in a bid to capture market share from non-OPEC countries.  The biggest threat to OPEC countries was the rise of the shale oil production in the USA. The “new normal” of low oil prices has several implications, and has changed the global economy significantly. The price drop has lowered the cost of living and increased real incomes for consumers in countries where the price declines have been passed on to users.

Similarly, firms using oil in production have benefited from lower input prices in these countries. The implied decline in firms’ marginal costs should translate into lower producer prices for their goods and services. These real income gains should result in higher spending and, other factors unchanged, a boost to global growth. At the global level, aggregate oil windfall gains and losses sum to zero. In several net oil-exporting countries, the oil price decline has interacted with other shocks (including fallout from geopolitical tension) to generate a significant macroeconomic adjustment. Major net oil exporters have managed to cushion, to some extent, the initial adverse impact on their output from the recent oil price decline by running substantial and rising fiscal deficits. Nonetheless, GDP growth in these countries has still declined significantly compared with the rest of the world. With spot crude oil prices falling well below fiscal breakeven prices, i.e. the prices required to balance government budgets (see Chart B), the fiscal situation has become increasingly more challenging in several major oil producers, particularly those with currency pegs to the US dollar or other tightly managed exchange rate arrangements (e.g. Iran, Iraq, Nigeria, Saudi Arabia, the United Arab Emirates and Venezuela). Monetary policy has also been constrained in commodity-exporting countries with more flexible exchange rates (e.g. Canada, Mexico, Norway and Russia). As the currencies of these countries have (sharply) depreciated, inflationary pressures have risen, thereby limiting the room for monetary policy easing in response to slowing growth. Finally, financial strains have exacerbated the downturn in prices, particularly in countries with foreign currency. However, oil importing countries like China and India have benefitted by reduction in their import bill. India’s fiscal deficit has improved since the country saved nearly $70 billion on importing crude and other petroleum products in 2015. The government was able to reduce petroleum subsidies and increase its excise duty on petrol and diesel, and can now redeploy that $70 billion into productive efforts. According to data from Rystad Energy, global upstream capital expenditure is forecast to decline by some 40% between 2014 and 2016. Moreover, this will have been the first time global upstream capital expenditure will have shrunk in two consecutive years, illustrating the severity of this downturn. There are regional variations to this decline. Europe, N America and Australia will witness the largest declines in capital expenditure while the Middle East will see the least.

During the past decade, American shale oil and gas producers pioneered a new business model that shattered the incumbents’ approach. U.S.-based shale oil producers have improved their drilling and fracturing technology, and they can ramp up production in an appraised field in as few as six months at a small fraction of the capital investment required by their conventional rivals. As a result, shale oil has soared from about 10% of total U.S. crude oil production to about 50%. That has enabled the U.S. oil industry as a whole to produce roughly 4 million more barrels of crude oil every day than it did in 2008, closing the gap between U.S. oil production and the world’s other two top producing countries, Russia and Saudi Arabia. In January this year, the U.S. lifted the 40-year-old ban on exporting American oil, and the maiden shipments are finding their way to global markets allowing U.S. oil producers to take advantage of markets that provide higher netbacks.

Another critical factor for the impact is the extent of price pass-through. Put simply, the issue is how much of the decline in world crude prices translates into a drop in petroleum prices at the retail level. Oil is always big news. Every increase in its price is thought to raise fuel costs to the detriment of consumers while generating huge income for foreign oil producers — such as OPEC Member Countries. But this is a misconception. While huge revenues are indeed generated, they are earned primarily by major oil consuming countries.* OECD economies, for example, earn far more revenue from the retail sale of petroleum products than OPEC countries make from the original sale of their oil. From 2010 to 2015, OECD economies earned on average about $1,381 billion/year more from retail sales of petroleum products than OPEC Countries made from oil revenues. A significant amount of the final retail prices of petroleum products is attributed to high taxation rates. In fact, during 2015, the share of total tax of the final retail price amounted to more than 50%. Moreover, between 2010 and 2015, OECD nations earned on an average $1,076 billion per year from taxes alone compared to OPEC’s $944 billion per year in oil revenues.

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At its Ministerial Conference on 30 November 2016, the Organization of the Petroleum Exporting Countries (OPEC) set the terms for reintroducing an oil production target of 32.5 million barrels per day. The agreement involves a cut in output of 1.2 million barrels per day, to be implemented through a uniform 4.5% reduction of each member’s supply, from January to June 2017. The global supply will be curbed by 1.9%, which compares with its 2.6% growth over the period 2015-16. This is the first time that OPEC and non-OPEC producers have agreed a coordinated cut in supply. The collaboration is underpinned by the various countries’ common desire to improve the financial conditions of their economies. In the long run the oil price remains tied down by the marginal cost of production. Structural market conditions have not changed in the meantime. If anything, the oil market has become even more competitive today than it was two years ago, as the cost-effective restructuring of the US oil industry and new technological progress have further reduced the shale wellhead break-even price by more than a fifth over three years. Crude is perhaps the only commodity whose actions command the first page, as well as business pages of a newspaper. Crude is not only a competition between producers and consumers, but is also intertwined with global geopolitics. Several global actions, like the Iraq-Kuwait war, Russia’s annexation of Crimea, have had their impact on the prices. The election of Donald Trump, who is in favor of reducing the dependence of the country on foreign oil, as well as geopolitical changes in the Middle East will have a tremendous impact on the oil prices, and hence the global economy. The future of oil prices is intertwined with the fate of the global economy, and any improvement in the global economy will see oil prices firming up. In today’s era of globalization, oil price is intricately connected with every aspect of our life.

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[This article is coauthored by Fizza Naaz]

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