Oil Price Slide – No Good Way Out

The world is in a dangerous place now. A large share of oil sellers need the revenue from oil sales. They have to continue producing, regardless of how low oil prices go unless they are stopped by bankruptcy, revolution, or something else that gives them a very clear signal to stop. Producers of oil from US shale are in this category, as are most oil exporters, including many of the OPEC countries and Russia.

Some large oil companies, such as Shell and ExxonMobil, decided even before the recent drop in prices that they couldn’t make money by developing available producible resources at then-available prices, likely around $100 barrel. See my post, Beginning of the End? Oil Companies Cut Back on Spending. These large companies are in the process of trying to sell off acreage, if they can find someone to buy it. Their actions will eventually lead to a drop in oil production, but not very quickly–maybe in a couple of years.

So there is a definite time lag in slowing production–even with very low prices. In fact, if US shale production keeps rising, and Libya and Iraq keep work at getting oil production on line, we may even see an increase in world oil production, at a time when world oil production needs to decline.

A Decrease in Oil Prices May Not Fix Oil Demand

At the same time, demand doesn’t pick up quickly as prices drop. We are dealing with a world that has a huge amount of debt. China in particular has been on a debt binge that cannot continue at the same pace. A reduction in China’s debt, or even slower growth in its debt, reduces growth in the demand for oil, and thus its price. The same situation holds for other countries that are now saturated with debt, and trying to come closer to balancing their budgets.

Furthermore, the Federal Reserve’s discontinuation of quantitative easing has cut off a major flow of funds to emerging markets. Because of this change, emerging market demand for oil has dropped. This has happened partly because of the lower investment funds available, and partly because the value of emerging market currencies relative to the dollar has fallen. Again, a decrease in oil price is not likely to fix this problem to a significant extent.

Europe and Japan are having difficulty being competitive in today’s world. A drop in oil prices will help a bit, but their problems will mostly remain because to a significant extent they relate to high wages, taxes, and electricity prices compared to other producers. The reduction in oil prices will not fix these issues, unless it leads to lower wages (ouch). The reduction in oil prices is instead likely to lead to a different problem–deflation–that is hard to deal with. Deflation may indirectly lead to debt defaults and a further drop in oil demand and oil prices.

Thus, oil prices are likely to continue their slide for some time, until real damage is done, perhaps to several economies simultaneously.

The United States’ Role in the Oil Over-Production / Under-Demand Clash 

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Eight Pieces of Our Oil Price Predicament

A person might think that oil prices would be fairly stable. Prices would set themselves at a level that would be high enough for the majority of producers, so that in total producers would provide enough–but not too much–oil for the world economy. The prices would be fairly affordable for consumers. And economies around the world would grow robustly with these oil supplies, plus other energy supplies. Unfortunately, it doesn’t seem to work that way recently. Let me explain at least a few of the issues involved.

1. Oil prices are set by our networked economy.

As I have explained previously, we have a networked economy that is made up of businesses, governments, and consumers. It has grown up over time. It includes such things as laws and our international trade system. It continually re-optimizes itself, given the changing rules that we give it. In some ways, it is similar to the interconnected network that a person can build with a child’s toy.

Figure 1. Dome constructed using Leonardo Sticks

Figure 1. Dome constructed using Leonardo Sticks

Thus, these oil prices are not something that individuals consciously set. Instead, oil prices reflect a balance between available supply and the amount purchasers can afford to pay, assuming such a balance actually exists. If such a balance doesn’t exist, the lack of such a balance has the possibility of tearing apart the system.

If the compromise oil price is too high for consumers, it will cause the economy to contract, leading to economic recession, because consumers will be forced to cut back on discretionary expenditures in order to afford oil products. This will lead to layoffs in discretionary sectors. See my post Ten Reasons Why High Oil Prices are a Problem.

If the compromise price is too low for producers, a disproportionate share of oil producers will stop producing oil. This decline in production will not happen immediately; instead it will happen over a period of years. Without enough oil, many consumers will not be able to commute to work, businesses won’t be able to transport goods, farmers won’t be able to produce food, and governments won’t be able to repair roads. The danger is that some kind of discontinuity will occur–riots, overthrown governments, or even collapse.

2. We think of inadequate supply being the number one problem with oil, and at times it may be. But at other times inadequate demand (really “inadequate affordability”) may be the number one issue. 
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OPEC says, ‘Don’t Count on Us’ for More Oil Supply

The results of OPEC’s latest meeting to set oil production quotas were announced this morning. Instead of production targets for individual countries, a group production ceiling of 30 million barrels a day was set. This amount is a bit less than OPEC produced in November 2011 (actual 30.367 mbd), according to its reckoning, and less than it would have produced most of 2011, if Libyan production had stayed on line, based on the amounts shown in its November Oil Market Report.

A recent history of oil production from the November Oil Market Report, both for OPEC and in total, is shown in Figure 1.

Figure 1. Recent oil production for World and for OPEC, according to OPEC November Oil Market Report.

According to a Platts report of the meeting, Venezuelan Oil Minister Rafael Ramirez told reporters, “We are going to reduce the level of production of each country to make space for Libya.” That is not what people want to hear–Brent oil price is still over $100 barrel, even with what seems to be record production for both the world and OPEC, based on Figure 1.

The same Platts report also says, “OPEC on Tuesday said it expected demand for OPEC crude next year to average 30.09 million b/d.” Thus, the new production cap is slightly less than what OPEC sees as demand going forward.

It should be noted that the new limit includes Iraq in addition to the “regular” OPEC countries. Thus, the agreement says that if Iraq increases its production, other OPEC countries will reduce their production to keep total production to 30 million barrels a day.  Continue reading

Why all of the Concern about Libya?

We keep hearing about unrest in the Middle East and Northern Africa, with Libya being the latest country to get top billing. Why all of the concern, especially related to oil?

Libya is a relatively oil-rich country. According to the CIA World Factbook, its per capita income is more than double Egypt’s. While Egypt is clearly on a down-hill slope with respect to exports based on my earlier analysis, Libya still has high export income and little debt. The fact that revolution could hit Libya shows that it is possible for revolution to hit any of the countries in this region, not just ones that don’t have the money to maintain their promises.

Figure 1. Libya's Oil Production and Consumption - EIA

One issue that Libya has in common with other oil producing countries is a high unemployment rate, listed as 30% by the CIA Factbook. Its population has been growing rapidly also, so there are many young people looking for work. While the country provides subsidies, this is not the same as each individual being able to provide for himself or herself. Continue reading