Energy Academic Group Seminar

February 20, 2014

The Causes and Consequences of The Oil Price Decline

Dr. Robert Looney, NSA

Overview I

• November 2014 decision by OPEC not to cut production reflects a profound shift in the world oil market.

• The demand for oil by China and other emerging economies is no longer the dominant factor.

• Instead, the surge in U.S. oil production, bolstered by additional new supply from Canada is decisive

• This surge is on a scale that most oil exporters had not anticipated.

• Normally, economists would consider the oil price drop a positive development, but this time there are doubts.

• Impacts will occur unevenly across oil exporters and importers making generalizations difficult.

• One of the greatest impacts may be the first phase of a new economics of oil paradigm – resulting in a realignment in global economic power

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Overview II

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Overview III

• The oil price drop was largely unforeseen by experts

• As late as October, 2014 a key concern of many analysts was the risk of an oil price spike caused by geopolitical tensions

• Rather than geopolitical tensions in Ukraine and Iraq causing a price spike, causality is from economics to politics

• The plunge in oil prices now threatens Russia’s public finances, and ability to destabilize the region

• In the Middle East the funds to finance vicious conflicts in Iraq and Syria face greater pressures which promise to stretch all sides. Iran may be compelled to sign a nuclear agreement.

• In the Caribbean and Latin America, Venezuela will loose much of its ability to influence policy and events through its Petrocaribe program of oil subsidies to neighboring countries

• In Nigeria the government will be hard pressed to fight Boko Haram

Outline

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Causes of the Oil Price Drop I

Causes of the sharp drop

•For any commodity, underlying demand and supply conditions determine the long run trend in prices

•Short term movements in market sentiment and expectations also exert influence

•Prices may drop rapidly due to surprises in the news --even before actual changes occur

•In 2014 relevant events included

• Geopolitical conflicts in some oil producing regions

• OPEC announcements, and

• The appreciation of the U.S. dollar

•Long term developments in supply and demand have also played important roles in driving the recent decline in oil prices

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Causes of the Oil Price Drop II

Trends in supply and demand•Recent developments in global oil markets have occurred against a long term trend of

• Greater than anticipated supply, and

• Less than anticipated demand

•Since 2011 US shale oil production has persistently surprised on the upside•Expectations of global demand have been revised downwards on several occasions during the period as economic growth disappointed.•Global growth in 2015 is expected to remain much weaker than during the 2003-08 period when oil prices jumped•The oil-intensity of global GDP has almost halved since the 1970s -- result of increasing efficiency and declining oil intensity of energy consumption

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Causes of the Oil Price Drop III

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Causes of the Oil Price Drop IV

Change in OPEC Objectives

•Saudi Arabia has traditionally acted as the cartel’s swing producer

•Using its spare capacity to either increase or reduce OPEC’s oil supply, and stabilize price within a desired band

•The OPEC decision in November, 2014 to maintain production level of 30mb/d signaled a significant change in cartel’s policy objectives

• From targeting an oil price band to maintaining market share

•No doubt, changed position reflects concern over increasing oil production from multiple sources

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Causes of the Oil Price Drop V

Receding geopolitical concerns about supply disruptions

•In second half of 2014 became apparent that supply disruptions from conflict in Middle East did not materialize as expected

•In Libya despite internal conflict production recovered by 0.5 million barrels a day (about 0.5% of global production) in the third quarter of 2014

•In Iraq, as advance of ISIS stalled, became apparent that oil output could be maintained.

•In addition, the sanctions and counter sanctions imposed on Russia have had little effect on oil and natural gas markets thus far

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Causes of the Oil Price Drop VI

U.S. dollar appreciation

•In the second half of 2014 the U.S dollar appreciated by 10% against major currencies in trade-weighted terms

•A U.S. dollar appreciation tends to increase the price of oil in non-U.S. currencies

•The decline in demand, and thus oil price often large

•Empirical estimates very greatly on impact on oil price

• The high estimates suggest a 10 percent appreciation is associated with a decline of about 10 percent in the oil price

• Low estimates suggest a 3% or less

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Causes of the Oil Price Drop VII

• Speculation• Beyond traditional demand and supply factors some have

suggested “financialization” of oil – development of sophisticated futures markets as a factor leading to the price decline

• Leads to greater likelihood of speculation in commodity markets

• However, little hard evidence that this is the case in the recent price drop

• Latest IEA report indicates that before the oil price drop inventories reached their highest level in two years

• Suggests expectations were of a price increase not decrease

• For the longer term – several trends important

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Long Term Drivers of Oil Price Decline I

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Long Term Drivers of Oil Price Decline II

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Winners and Losers Overview

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Winners: U.S. I

• Falling oil prices may slow down the shale revolution but are still good news for the U.S. economy

• Cash saved by consumers on gasoline will provide about $75 billion to spend on other goods – about 0.7% of total US consumption

• Some analysts predict a fall in oil investment, but Goldman Sachs pegs it at no more than 0.1% of GDP

• Lower oil prices have made economists more confident about the outlook for 2015

• HSBC has raised its growth forecast from 2.6% to 2.8%• Cheaper oil will weigh on already low inflation, but the

Federal Reserve is ready to act if deflation looks like a possibility

• Impact mixed across states – some winners, some losers.• Some banks increasingly vulnerable

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Winners: China

• China benefits less than might be expected from falling prices despite being the world’s largest oil importer

• Partly because the heavy reliance on coal means most of the economy is exposed to oil prices through the transport sector.

• Diesel and petrol prices set by the state stop closely tracking oil prices at around $80 a barrel.

• Good news for state-owned oil refiners CNPC and Sinopec, but less so for businesses and drivers.

• Several of China’s banks are also heavily exposed to major oil exporters including Venezuela, leaving China vulnerable when falling prices hit those country’s ability to repay loans

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Winners: Japan

• Japan is a clear winner from falling crude prices• In the last fiscal year to March 2014 the country spent

$236bn on fuels, of which more than 90 percent was linked to oil.

• For every 10% drop in the price of a barrel represents about $21.6bn

• A 30% drop in oil hands back about as much cash as was raised by the government this year when it increased the consumption tax by 3%.

• In effect a narrowing in the country’s budget deficit has been totally paid for from aboard.

• However lower oil is a mixed blessing for the Bank of Japan – could make it more difficult to achieve its 2% target for inflation -- country may slip again into defilation.

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Winners: Eurozone I

• The EU imports 88 percent of its oil, but the picture is mixed

• At first glace lower energy prices very positive:

• Come as welcome relief to European industry struggling to retain competitiveness with the US

• In terms of consumer prices cheaper is a mini-stimulus package – still problems:

• Still problems:

• Problem for the ECB – inflation already low and veering towards deflation

• Many countries have looked to inflation to alleviate the debt burden that is restraining spending power

• Oil’s freefall has also battered European stocks, particularly London’s energy-heavy FTSE

• Some smaller oil exploration companies facing bankruptcy 19

Winners: Eurozone II

• Other problems:

• Major projects in Europe such as Britain's North Sea will be put on hold

• For Germany overall positive

• While country is shifting towards renewable power petroleum still makes up about a third of energy consumption

• Business confidence has been boosted by cheap oil and the decline of the Euro

• German GDP is expected to grow by 1.5% in 2015 of which a quarter percentage point is attributable to the drop in oil prices

• Oil price decline expected to boost overall economic activity through an increase in domestic purchasing power

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Winners: UK• With rapidly declining oil extraction in the North Sea,

most of the UK is a modest winner from oil price drop.

• For Aberdeen the oil capital of Scotland and the UK, outlook is bleak since the city specializes in deep sea oil extraction technologies which are increasingly uneconomic with cheaper oil

• But Aberdeen’s loss is the rest of the UK’s gain

• Lower fuel prices have pulled inflation down to 1 percent and have

• Eased pressures on household and company budgets

• Raised confidence

• Improved the growth prospects for 2015

• For the public finances the outlook is less rosy as the oil industry is heavily taxed

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Losers Overview: Budget Balancing

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Losers: Nigeria

• Nigeria’s emergence as Africa’s largest economy due mostly to rapid growth in services

• However, country still depends on oil for more than 60% of state revenues and 90% of export earnings

• Compounding the problem is the escalating Islamist insurgency in parts of the North.

• Oil production is down – averaging well below its 2.4mb/d capacity due to massive theft and a lack of investment following five years of legislative paralysis over reforms for the industry – the result.

• Foreign portfolio investors have taken flight

• The government has slashed spending for 2015

• The stock market was down 23 percent in 2014 and

• The country’s currency has had a massive devaluation

• Infrastructure constraints will increasingly limit growth. 23

Losers: Iran • Iran holds the world’s fourth largest reserves

• Country already struggling with impact of Western sanctions before oil began to fall

• Government is seeking to rebalance the economy to reduce its dependence on oil

• From around 50% to closer to one third – would be the lowest in decades

• With no prospect of oil prices going up in the near future there is added pressure to strike a nuclear deal before the June deadline

• US banking sanctions have cost Iran half its oil revenues.

• An agreement could potentially allow Iran to sell more crude and have access to about $100bn of foreign exchange reserves which it has been barred from accessing

• Failure could lead to a further shrinking of the economy and social unrest 24

Losers: Saudi Arabia

• Fiscal buffers are in place to offset the impact of any potential domestic deficit.

• Still, country will be among the country’s most affected by lower oil prices

• Oil receipts average 85% of exports and 90% of fiscal revenues• At $60 a barrel the country would have a fiscal deficit of

around 14% of GDP in 2015• Its vast foreign exchange reserves of $750bn will offset much

of negative effects of lower oil prices• Although denying it, likely pullback in spending on social

programs which had increased substantially following unrest during the Arab spring

• Even so, Saudi Arabia has used leading position in OPEC to resist calls for a production cut.

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Losers: Venezuela • Venezuela is estimated to lose $700m for every dollar

drop in the price of oil – oil 96% of export revenues

• Even before the 2014 oil price drop, there was speculation the country might have to default.

• These fears have intensified with the economy shrinking 3% in 2014

• Population is struggling with shortages of basic goods and inflation is running at more than 63%

• Estimates are the country needs a price of above $130 to balance its budget

• To cover some of the losses the country needs to increase production to between 2.4mb/d and 2.8mb/d but even under the best circumstances that would take years to come on stream.

• PetroCaribe??26

Losers: Russia

• For the Russian economy, the drop in the price of oil and the Ukraine crisis have created the perfect storm.

• Oil and gas account for 75% of the country’s exports and

• More than half of its budget revenues

• Its currency moves closely with the oil markets – falling significantly in 2014 due also to geopolitical risks

• As a result, the $600bn burden that Russian banks and companies owe foreign creditors is getting heavier by the day

• Debt servicing complicated due to western sanctions baring most borrowers from refinancing this debt with US or European banks

• With Russia reliant on imports for almost everything except commodities, inflation is expected to rise to above 10%

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Losers: Mexico • Mexico is opening up its oil and gas sector to private

investment after nearly 80 years of state control

• Stands to see investment squeezed as a consequence of the oil price decline

• Companies vying for the chance to drill $100m wells say they may scale back their investment

• Silver lining

• The country imports about half its gasoline so lower prices are a bonus.

• Crude accounts for less than 15% of Mexico’s exports

• Country has a hedging program which it says will shield it from the impact of crude price declines in 2015

• A $20-a-barrel fall in the price of Mexico’s oil in 2015 would add up to less than 1% of GDP

• Not insignificant, but fiscally manageable – Moody’s 28

Losers: Canada

• The Canadian energy sector accounts for 23% of exports and approximately one-third of capital spending

• Many Canadian oil sands projects have operating costs in the 40-60 dollar range and will remain profitable if prices stay in that range

• Production expected to grow by 5-6% a year in the near term: most imminent production was planned years ago

• Current prices will only have an impact on production growth later in the decade

• Growth in oil sands has typically been more closely tied to demand rather than price

• Lower prices will reduce Canadian GDP by 0.1% and growth down by 0.20-0.25% from 2.4% before price fall

• Government revenues will decline by C$500 million in 2014 and C$2.5bn annually from 2015-19 if WTI hovers around 81$ 29

Global Economy I

• As a rule a rule, $US10/b decline in oil prices transfers roughly 0.5% of world GDP from net exporters to net importers

• As importers have a higher propensity to save, the net effect is to increase global demand.

• Extent of impact depends on:

• Whether the oil price decline is driven by supply or demand – supply will have the greater impact. Current situation supply shock

• How much of the oil dividend accruing to oil importers is spent – given on going de-leveraging from the 2008-09 crisis, less likely to be spent than in the past

• How much the price of oil changed to end-users accounted for by taxes—greater share – less impact

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Global Economy II

Extent of boost depends on (contd.)

•Whether governments that subsidize fuel take opportunity offered by lower prices to cut subsidies and raise taxes – blunt impact of lower prices

•Exchange rate movements – recent decline in oil price coincided with dollar rally – decline in oil prices in euro and Japanese yen less marked in dollar terms – many emerging currencies have fallen sharply against the $

•By the IMF rule, oil price drop should increase global GDP by 0.4%

•Taking into account factors noted here the figure may be closer to 0.25% -- 0.30%

•The U.S. likely to be the biggest winner in total $ terms.

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Future Oil Prices

• Many analysts feel movements in future oil prices are likely to be influenced by several key factors:

• Future supply/demand conditions

• OPEC strength/objectives

• Geopolitical factors

• Movements in demand

• As a general rule, lower oil prices today, by reducing investment, result in higher prices in the future

• Key question – how has shale modified this relationship?

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Future Supply Conditions I

How persistent is the supply shift likely to be?

•Depends on two factors

• First is whether OPEC and in particular Saudi Arabia will be willing to cut production in the future

• This depends in part on the motives behind the change in its strategy and the relative importance of geopolitical and economic factors in that decision.

• One hypothesis is that Saudi Arabia has found it too costly, in the face of steady increases in non-OPEC supply, to be the swing producer and maintain a high price – other countries free ride at Saudi expense

• If so, and unless the pain of lower revenues leads other OPEC producers and Russia to agree to share cuts in the future – strategy unlikely to change in the near term.

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Future Supply Conditions II

• A related hypothesis is that it may be an attempt by the Saudis to reduce profits, investment, and eventually supply by non-OPEC suppliers, and even OPEC suppliers

• Some of whom face much higher costs of extraction than the Saudis

• The Second Factor is how investment and in turn oil production will respond to low oil prices.

• Exploration and production budgets for 2015 face significant curtailment

• Major projects in high-cost oil basins will be cancelled or postponed

• However the time lag between investment and production means that additions to supply will continue to come on stream for some time

• Many projects are simply too far ahead to be stopped 34

Future Supply Conditions IV

• For unconventional oil such as shale (which now accounts for 4 million out of a world supply of 93 million barrels a day):

• The break even prices – the price at which it becomes worthwhile to extract in the U.S. are typically around $60 per barrel

• However a new analysis based on individual well data finds that 80% of new tight-oil production in 2015 would be economical between $50 and $69 a barrel

• Companies will continue to improve technology and drive costs down.

• Still with prices near or below $60 a barrel, U.S. companies are looking hard at their investment plans – where and how much to cut or postpone.

• But it will take time for these decisions to affect supply

• U.S. output will continue to rise in 2015 35

Future Supply Conditions V

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• Break-Even Prices for U.S. Shale basins

OPEC I

• An effective cartel requires three things:

• Discipline

• A dominant market position, and

• Barriers to entry

• OPEC lacks all three

• Its members cheat on quotas,

• It supplies only 30% of the world’s oil – too little to exercise control and

• New producers abound

• OPEC more follows the a dominant firm model than a cartel

• Saudi Arabia its most influential member could have sent the price up simply by deciding to pump less

• The Kingdom has savings of $900 billion 37

OPEC II

• But Saudi Arabia can also weather a low price• Its production costs are $5-$6 a barrel – the lowest in the world• History suggests most of the gains from any cut in its output

would go to other producers who would sell their oil for more while increasing their market share

• Saudi Arabia did try this tactic in the early 1980s cutting its output drastically

• Result -- higher prices but also a boom in investment and then production in places like Britain and Norway

• Trying to save OPEC with such tactics could be even more dangerous now

• Cheap oil has its consolations for Saudi Arabia

• Russia and Iran two countries which the Saudis have differences are hurt much more

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Likely Future Prices I• Likely developments regarding future supplies, and

OPEC strength impacting on future prices suggest little upwards pressure.

• This is also the market interpretation -- futures markets now show an expected recovery of prices into 2016

• However, uncertainty comes not only from supply, but also geopolitical and demand factors

• Geopolitical Factors

• geopolitical tensions in Libya, Iraq, Ukraine and Russia should not be underestimated

• Demand Factors

• High uncertainty about global economic activity, especially in the Eurozone and China, and thus the derived demand for oil

• Not much optimism now for rapid global expansion.

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Likely Future Prices II

• Short Run Oil Price Movements

• Currently the oil market is massively oversupplied

• Unless OPEC acts as a swing supplier a glutted market is highly unlikely to be avoided given the lags involved in curbing production.

• Some supply curtailment is already evident in early 2015 especially in U.S. shale

• However there will be a substantial inventory overhang through most of 2015

• Demand for oil should increase somewhat given lower prices and by early 2016 demand and supply should once again be in balance.

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Future Prices V

• Several factors might modify this outlook

• Key downside risk

• instability in Eurozone results in many countries falling into recession

• Key upside risks are

• an acceleration in demand particularly with China topping up its strategic reserves, or

• A supply disruption sparked by geopolitical frictions,

• Baring these, oil prices should reach approximately $78 in 2016 and continue to firm up further in the ensuing years.

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Future Prices VI

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U.S. Energy Security I

Implications for U.S. energy security

•We define energy security as the ability of households, businesses and government/military to effectively manage disruptions in energy supply.

•Traditionally low prices have been looked on as reducing energy security because they

• Undermine incentives for investments in energy expansion and efficiency

• May remove sources of revenue that deter investors from upgrading or expanding energy infrastructure that that could enhance the reliability of the energy system.

•Countering these two tendencies are

• The prospect of rising prices beginning in the first part of 2016 and,

• Developments in global markets that may have fundamentally altered the economics of oil

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Energy Security II

How will U.S. energy security be affected?

•With the good prospect of markets firming up again in 2016, whatever loss in energy security has occurred because of the oil price decline, should be quickly reversed.

•In addition the period of low prices are unlikely to have an adverse effect on alternative renewable energy supplies

•The period of low oil prices has demonstrated the weakness of OPEC.

• That organization unlikely to play a major role in the future in constraining energy supplies

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U.S. Energy Security III

• Most importantly the oil price drop demonstrated that there is a new economics of oil

• In the past, new supplies of oil had come from large expensive fields with a long lag between price increases and subsequent follow on investment

• Today, a shale-oil well can be drilled in as little as a week and at a fraction of the cost of conventional oil

• Process is a little like manufacturing drinks – whenever the world is thirsty, you crank up the bottling plant.

• Shale development should reduce volatility in oil markets while providing the world and the U.S. with diversified sources of oil – both enhancing energy security

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U.S. Energy Security IV• In addition there appears to be underway a shift in

conventional oil production

• away from unstable higher cost sources --- Venezuela, Russia, Nigeria, and Iran

• toward more secure lower cost locations -- specifically the GCC

• The GCC is determined to maintain market share and to do this they are expanding productive capacity and will likely hold the price lower than in the past to accomplish this – in effect replacing OPEC

• Their output will come at the expense of higher cost countries• Saudi Arabia has sustainable oil production capacity of 12

million b/d• Kuwait is investing in sustainable capacity of 4 million b/d

and Abu Dhabi going for 3.5 mill b/d

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U.S. Energy Security V

• By 2020 the six GCC states could be in the position to produce 21 million b/d

• Why Should the GCC countries change their strategy?

• Markets since 1973/74 have allowed the GCC OPEC states to meet global demand at times of supply interruptions elsewhere and to adjust exports to meet OPEC price targets

• Supply risks remain but they are much lower. Consuming countries have

• Increased strategic reserves

• Diversified away from potentially unreliable oil and gas sources

• Boosted domestic energy production and

• Promoted renewables

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U.S. Energy Security VI

• There are good reasons for the GCC to radically raise production and exports

• We are entering an era where production efficiency rather than control of reserves will be decisive

• Neither Saudi Arabia nor OPEC will be able to prevent a secular and structural decline in energy prices

• If the GCC wants to maintain its oil and gas income, it will have to increase hydrocarbon exports

• Lower prices in turn will weaken three U.S. adversaries Russia, Iran and Venezuela

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U.S. Energy Security VII

• If Saudi Arabia and the GCC lift production as much as possible US-GCC combined production will exceed 30 million b/d by 2020.

• This is a figure higher than OPEC’s 2014 production and would be equivalent to about 30% of forecast world demand for that year.

• It would be enough to ensure the GCC working with the US for a generation and more will be able to shape the structure and direction of global energy

• These oil price trends and associated developments should considerably enhance U.S. energy security.

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Questions

• Questions?

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