Oil Prices Have Been Falling For Months, And That’s Likely To Have Wide Repercussions
Quietly, oil prices have been falling for months now. That's potentially a very big deal.
While the world has been spending the last several months paying attention to everything from Ukraine to the rise of ISIS to Ebola, there’s been something interesting going on in world oil markets. Starting roughly in June, the per-barrel price of oil has dropped from well over $100/barrel to something closer to $80/barrel. You may have noticed it at the local gas station where prices have been falling consistently to the point where many parts of the country are already seeing prices under $3.00 per gallon for regular unleaded. Given the fact that we’re in the middle of an incredible tense period in the Middle East given the recently concluded Israel-Hamas War over Gaza and the ISIS situation, the falling prices seem somewhat surprising, but Isaac Amsdorf provides a pretty good explanation for why it happened, and The Atlantic’s Derek Thompson argues that we could see prices fall even further:
Gas prices are falling below $3 a gallon across the United States for two big reasons: (1) the world economy is growing slower than we hoped, and (2) global oil production is improving faster than we expected.
“India and China are slowing down,” said Charles K. Ebinger, director of the Energy Security Initiative at Brookings. “The IMF just downgraded Europe’s growth to less than 1 percent, and they’re already quite energy efficient. Brazil’s a problem, too. All around the world there is no great growth story, and expectations are that things will stay that way or get worse.”
There is also unanticipated supply. A few years ago, political turmoil was taking up to 2 million barrels a day off the market. Now production is roaring back in Libya, southern Sudan, Yemen, Nigeria, and even Iraq, and the global price of crude has fallen about 25 percent in the last five months. It’s the same old story: low demand, high supply, etc.
Andrew John Hall, the alleged “God” of oil trading, is predicting $150 barrelswithin the next five years. But the deeper you dig, the more reasons you find to be down on the price of oil in the near future. “Japan’s announcement that they’re starting two reactors means that there will be less oil import for Japan,” Ebinger said. Second, there are industrial shifts that are reducing oil’s share in the energy market. For example, many U.S. companies are using natural gas rather than petroleum products to power their refineries. Third, hedge funds went long on crude when they saw the Middle East flaming up. But as the price has moved against them, they’ve dumped oil into a soft market, further driving down the price of crude.
It’s hard to say how the sliding price of gas will affect the United States, as a whole, because the economy is a messy mix of cities, industries, and consumers behaviors, each of which experience falling prices differently. In cities with lots of driving and not much energy production—e.g. throughout California—cheaper gas is simply good, the end. Three-buck gasoline gives back as much as $500 a year to the typical family with two cars, compared to the $4.50 gallons from a few years ago.
It’s easy to see the positive benefits for the U.S. and other nations that use petroleum based products in large amounts from falling oil prices. Falling prices for oil will eventually filter through to the prices of the products derived from oil itself, including not only gasoline but also home heating oil and jet fuel. In the short and medium term, this would provide some relief for consumers and for companies that depend on transportation such as Wal-Mart, Amazon, airlines, and shippers such as UPS and Fed-Ex. If prices continue to fall, those benefits will become more apparent and could help to boost economic growth at least slightly, which would be good news for the jobs market and even tax revenues and the Federal Budget Deficit. Other nations that are oil dependent would likely experience similar benefits, which would be good news for areas like Europe where the economy seems to be slowing down a bit and for the world as a whole, which in turn would be good news for nations that are dependent on international trade, which is pretty much every major industrialized nation at this point.
Falling oil prices are likely to be less of a good thing for industries and nations that are focused on energy production, though. Already B&P and Royal Dutch Shell have reported lower 3rd Quarter earnings due to falling prices, and we’re likely to see the same from other oil companies and refiners as they report their earnings going forward. Here in North America, there is at least some concern that falling prices could have an impact on the energy boom we’ve seen in states like North Dakota and Canadian provinces such as Alberta thanks to the shale oil boom. Extracting oil from shale is an expensive process, and it requires that oil prices stay at certain levels so that the process remains profitable. If prices continue to fall, that shale boom could be put in jeopardy. Fortunately, analysts have been suggesting that the domestic shale extraction business could weather a further decline in prices and still remain profitable, with some analyses suggesting that the industry would be able to sustain price drops even below $60/barrel. Another potential loser from price drops, of course, would be OPEC, which could respond to further declines by decreasing output as they have in the past. At present, however, the organization is saying that there are no plans to cut production. If that remains true, then there doesn’t seem to be any reason to doubt that we’ll see the current trend continue at least in the short term, and possibly longer.
One nation that could feel real pain from an oil price drop, though, is Russia:
Vladimir Putin’s math is looking fuzzy. Russia’s budget is based on oil trading for $100 a barrel, government documents reveal.
Finance minister Anton Siluanov calls that an “alternative economic reality.”
Oil currently trades around $80 a barrel.
Siluanov warned that cuts will be needed since the budget doesn’t reflect the hits Russia’s economy has taken from the standoff in Ukraine and falling oil prices.
When Russian parliament passed the draft budget for 2015-2017 last week, it assumes that oil trades at $104 a barrel for 2014 and $100 for 2015-2017. That might have made sense when oil traded at $115 in June, but not now.
The result: Russia has a huge hole in its books.
And it might get worse. Goldman Sachs (GS) and top bond investor Jeffrey Gundlach predict oil could fall as low as $70 in the coming months.
Related: Crashing oil prices could crush Vladimir Putin
The finance minister is already talking about the need to cut spending by 10% to offset the “difficult economic situation.”
“The budget can not constantly have expenses that were made at different economic reality,” Siluanov told the parliament.
USA Today’s Anna Arutunyan points out that, beyond budgeting issues, continued price drops could end up pushing the nation into recession:
MOSCOW — If sanctions, inflation and political risk weren’t enough, falling oil prices are pushing Russia’s already beleaguered economy toward recession.
The price of Brent crude oil, a global benchmark, hit a four-year low last week, plunging to below $83 per barrel from $116 in June. While it was just under $85 on Wednesday, there is considerable risk it could dip well below $80, costing Russia, whose budget gets half its revenue from oil and gas exports, billions of dollars, analysts said. Geopolitics and oil prices have already reduced Russia’s budget by an amount equal to 4% of its gross domestic product.
A loss of “$10 per barrel costs (Russia) 500-600 billion rubles a year” — equivalent to $12.2 billion to $14.6 billion, said Natalia Orlova, chief economist at Alfa Bank, by telephone.
Cheap oil has further devalued Russia’s currency, with the official exchange rate falling almost 20% this year to 41.34 to the dollar Wednesday. Months of economic instability largely due to Western sanctions over Russia’s incursion into Ukraine have already taken their toll, with the latest round of sanctions cutting off Russian companies from Western financing.
: Slumping oil prices likely to push U.S. gas prices lower
The troubles in Russia — the world’s eighth-largest economy — could have global repercussions. Deterioration of Russia’s credit could affect the health of some European banks along with economies in Europe and Central Asia that rely on trade with Russia. Economic instability would be particularly risky for Russia itself, where President Vladimir Putin’s rule at home owes much to the stability that’s come from high oil prices and relative prosperity for the population.
Moody’s downgraded Russia’s sovereign debt from Baa1 to Baa2, the second-lowest investment-grade rating, on Oct. 17, adding further pressure on the ruble, potentially raising Russia’s borrowing costs.
Russia has been forced to spend some $13 billion this month to support the ruble and keep it from free fall.
The one silver lining is that since Russia exports in dollars and spends in rubles, so the ruble’s devaluation means there are more rubles for every dollar it gets in oil revenue.
“This year we have made more than 1.5 trillion rubles ($36.5 billion) on the ruble’s devaluation,” Orlova said.
But that buffer could quickly run out if oil prices remain low or continue falling. That appears likely given the Organization of the Petroleum Exporting Countries’ inclination to keep production levels up in the face of a global oil surplus, according to the International Energy Agency.
“If oil price continues to fall at the same rate, the negative effect for the GDP will increase,” said Alexander Golovtsov, chief analyst at Moscow’s UralSib Asset Management, by telephone. “If oil falls to $75 per barrel, we could lose up to 3% of economic growth. That would somewhat deepen the recession that’s about to get underway.”
The money debate is overshadowed by political questions about the cost of Russia’s annexation of Crimea in March and its incursion into Ukraine, where a conflict between a new, pro-Western government in Kiev and pro-Russian rebels in the East has claimed more than 3,500 lives.
Crimea’s infrastructure and development alone will cost the Russian budget up to $4.5 billion a year, according to the Ministry of Economic Development. The cost of the incursion itself is impossible to estimate, because Russia has consistently denied sending weapons or soldiers to Ukraine, claiming only volunteers were fighting on the side of the rebels.
Earlier this month, Siluanov said that falling oil prices and geopolitics have already cost the Russian budget 4% of the GDP, according to Itar-Tass.
There’s also a geopolitical angle to the impact of falling oil prices on Russia. Over the past six months, the West, led by the United States, has imposed an expanding series of economic sanctions against Russia over its annexation of the Crimean Peninsula and its active encouragement, and not-t0-subtle hidden and open participation, in the rebellion by pro-Russian rebels in eastern Ukraine. While the sanctions have resulted in some Western goods disappearing from shelves in Russia and price increases, Moscow has largely been able to avoid any real consequences thanks to the cushion provided to the economy by revenues from its oil and natural gas reserves. If the price of oil continues to drop, then that cushion could disappear and the Russian economy could decline, causing pain not only to ordinary Russians but to Russian oligarchs and their business interests and, of course, to the nation’s budget and monetary stability. Given the fact that we’ve seen a year in which Russia has been flexing its muscles far more than in the past not only in Ukraine, but also with subtle threats against Estonia, Moldova, and Kazakhstan and reports of Russian airplanes resuming old Cold War positions near Alaska and over Europe, and even recent news of a Russian sub in Swedish waters, it’s hard to predict how Vladimir Putin would react to such economic developments. Would it make him more willing to talk with the West about backing down from the recent aggressive posture, or would it be something that causes the Russian bear to become more aggressive to the point where the West would be required to respond further? I’m not going to hazard a guess at this point, but it seems like it will prompt some kind of response and, given the fact that we’re living in a world where there is so much already going on that could arguably called a crisis, it could prompt yet more headaches for the White House and other nations that will be forced to deal with what Putin does whether they want to or not.
All of this could be very short lived, of course. OPEC could decide that the declines have gone far enough and slow down production as they have in the past notwithstanding the current assurances that this will not happen. Tensions in the Middle East due to the ISIS war could increase sufficiently that traders start bidding the price of oil back up due to increased risks, this would seem to be especially true if ISIS forces started making moves toward the oil fields in Iraq’s south between Baghdad and Basra that cause supply disruptions. Supplies from the recently reactivated fields in Libya could be threatened by the sectarian war that seems to be developing there, further cutting in to world supplies. The world economy could improve significantly from current doldrums, which would have the effect of increasing demand and thus likely increasing prices. For the short term at least, though, it looks like prices will either stay roughly where they are or continue to fall, and that’s going to have both good and potentially bad consequences worldwide.