The great fall of black gold

Published Jan 13, 2016, 3:50 am IST
Updated Jan 13, 2016, 7:40 am IST
Crude oil has been called black gold for nearly over a century.
Major oil producers continue to pump in enormous amounts of crude oil leading to an unprecedented supply glut.
 Major oil producers continue to pump in enormous amounts of crude oil leading to an unprecedented supply glut.

Hyderabad: Nearly a year ago, at the peak of Delhi Assembly poll campaign, Prime Minister Narendra Modi’s luck had almost become one of the USPs of the BJP. Addressing a rally, Mr Modi had said, “Let’s accept that I am lucky but you have saved money (due to low petrol and diesel prices). If, because of my good luck, prices of petrol and diesel get reduced and the common man saves more, where is need to elect someone who is unlucky?” Even a year later, Mr Modi’s luck endures as major oil producers continue to pump in enormous amounts of crude oil leading to an unprecedented supply glut. The result is the price of crude oil, which had  touched $140 a barrel in mid-2008, sunk to 2004 levels of $31.56 a barrel on Tuesday.

Has the crude oil price bottomed out?: Not yet, according to global financial services firm Morgan Stanley. In its report on the outlook for crude oil price, a rapid appreciation of the US dollar and global slowdown may send brent oil to as low as $20 a barrel.A high crude oil price has always pushed India into a crisis-like situation — during the 1990s, the oil price hike after the first Gulf war and a sustained high price between 2008 and 2014 — whose impact led indirectly to the downfall of incumbent governments. As it is a commodity of great importance — political, economical and social — a low price is always beneficial to a consumer country like India which depends mostly on imported fuel.

For a layman, however, it is but perplexing to know that the world’s largest cartel Opec was not able to fix the fuel price — the bread and butter of oil producing countries. Opec can theoretically fix whatever price  the group wishes to merely by reducing oil production to correct the demand-supply mismatch. However, various factors are at play in the global energy market which are inhibiting oil producing countries from taking such a simple step instead of facing a difficult slowdown in their economies. For example, Saudi Arabia needs crude oil price to be at least $91 a barrel to continue its economic growth unhindered. But it chose to accept the lower price and endure difficulties. Why? The first and foremost reason is the competition between the Saudi Arabia-led Opec and US shale oil producers. Because of technological advancements, the US has been able to produce enough oil for domestic consumption, forcing Saudi Arabia — the main supplier of oil to the United States — to seek new markets.

Competition in markets: America being the oil consumer market has suddenly and drastically reduced the demand for Opec oil. With most Opec countries and Russia solely dependent on oil revenue for their economy, the supply remained unchanged, leading to a fall in crude prices. The re-entry of oil supply from Iraq and prospects of Iran resuming its production post-sanctions made the oil market bearish.In October 2014, Saudi Arabia and Russia, two major oil producers, informally discussed the prospects of a supply cut to resurrect oil price to over $100 a barrel. But the outcome was nil as Saudi Arabia was reluctant to cut supply over fears that its competitors will use it as an opportunity to increase their own market share, as they had done during the crude oil crash in the 1980s.

This policy leaves Saudi Arabia — whose oil production cost is the lowest at around $10 — with only one option, and that is to allow crude oil price find its bottom and wait for high-cost oil producers like US shale oil companies and North Sea companies to exit the business due to an unviable low price.

Low prices for long time: But Saudi Arabia’s wait to get back to its comfort level of $91-a-barrel may be unduly long as US shale oil companies are improving operational efficiencies to further lower break-even points (a price point at which the company can meet all its expenses). According to Citi report, the oil production cost in Mexico and western Canada has come down to less than $30 a barrel, below the current benchmark prices of $31.3 and $31.5 for WTI and Brent crude respectively as they shift to most economical horizontal hydraulic fracturing for oil extraction.

According to a US Energy Information Administration report, shale oil production in seven of the largest US oil and gas producing regions is going to decline in February compared to January by 116,000 barrels per day. The biggest shale oil producer Eagle Ford could, however, continue to remain profitable at $50 a barrel, while most others are comfortable with $70 — a level beyond this would set alarm bells ringing in the Indian finance ministry.

Low demand scenario: Will exit of high cost shale oil cos increase crude prices to $100? No. Not necessarily, because there are both supply and demand factors which may not allow crude oil price to reach this level again. If the price ever crosses $70 a barrel, shale oil companies will resume oil production to bring down the price again. Apart from this, the global economic slowdown, especially in world’s second largest oil consumer China, will not allow demand to go back to 2008 levels.

Apart being the second largest consumer of crude oil, the booming Chinese economy had become a growth engine for commodity-exporting countries like Australia, Russia, South Africa, Nigeria, Brazil, Venezuela, etc between 2008 and 2014. But with China slowing down, a proportional demand for crude oil coming from the supplicant countries too will decline. A resultant economic slowdown in oil-producing countries will also lead to lower global consumption of non-oil products, which will in turn reduce the industrial demand for oil and oil-related products. So a return to $100-level is almost impossible.

Energy efficiency: Other factors that could further bring down the crude oil consumption are the introduction of efficient energy technologies and a focus on preventing climate change. The increased affordability of fuel cell technology will reduce automotive demand for crude oil. According to Goldman Sachs, crude oil price will further drop in the coming months as the demand for crude oil for creating strategic reserves will probably end as the storage tanks will reach their limits, bringing down the actual demand.

Dollar impact: Meanwhile, Morgan Stanley claims crude oil price will reach $20 or $25 a barrel if the US dollar continued to appreciate. Crude oil price will fall if US dollar gains its purchasing power. It feels that the strong US dollar is the main factor that brought down crude oil price to near $30.

“A global glut may have pushed oil prices under $60 a barrel, but the difference between $35 and $55 is primarily the US dollar,” Morgan Stanley claimed in the report. How the current scenario will play out over the coming months, or even years, remains to be seen.

Crude oil priceCrude oil price

Top 10 consumers of oil:

1. United States:  18.961 mbc/day
2. China:  10.480 mbc/day
3. Japan:  4.531 mbc/day
4. India:  3.660 mbc/day
5. Russia:  3.493 mbc/day
6. Brazil:  3.003 mbc/day
7. Saudi Arabia:  2.961 mbc/day
8. Canada:  2.431 mbc/day
9. Germany:  2.403 mbc/day
10. South Korea:  2.324 mbc/day

Top 10 producers of oil:

1. United States:  12.5 mbc/day
2. Saudi Arabia:  11.6 mbc/day
3. Russia:  10.8 mbc/day
4. China:  4.4 mbc/day
5. Canada:  4.3 mbc/day
6. UAE:  3.5 mbc/day
7. Iran:  3.4 mbc/day
8. Iraq:  3.3 mbc/day
9. Mexico:  2.8 mbc/day
10. Kuwait:  2.8 mbc/day

What might happen to India if crude oil price crosses $100: According to current retail prices, India will be comfortable in terms of fiscal deficit until crude oil stays below $70 a barrel. In the hypothetical scenario of crude oil touching the $100 mark, it may force the government to subsidise at least politically crucial items like LPG, kerosene and diesel. It means the government will have to foot the subsidy bill of around Rs 70,000 crore.

A higher crude oil price means higher payout for imports. A higher import bill in the current scenario of global slowdown would have widened the current account deficit (the gap between total receivables and payments in dollar terms), causing stress on our foreign reserves. This will lead to rupee depreciation and a consequent capital flight from equity markets. A higher subsidy would lead to higher fiscal deficit (unless government does not cut expenses under others heads or increases its non-tax revenue).

A higher fiscal deficit will invariably be financed by debt. This will crowd institutional lending in favour of the government, making it difficult for companies to access institutional credit for investment and expansion purposes. A higher but inefficient spending by the government will fuel inflation, leading to a drop in real returns for foreign investors. Any reduction in real return will force foreign investors to exit Indian debt and equity markets, which will reduce foreign reserves and lead to a drop in rupee value. Depreciation in rupee value will again increase fuel price in rupee terms and continue the vicious cycle (unless India reduces oil consumption or increases dollar revenue through higher exports).

Most industrial metals plunged over China slump: After the 2008 financial meltdown, China started a huge stimulus programme to boost its economic growth by investing huge amounts of money in building new bridges and roads and highrises — practically building cities where no one lived. The Chinese infrastructure spending boosted the global demand for industrial metals like iron, steel, copper, aluminum, coal, etc and served as stimulus to commodity exporting countries like Australia, Brazil, Indonesia, South Africa among others.
In no time, China has overtaken the United States to become the largest consumer in the world, with Beijing’s share at nearly 25 per cent and   the US shrinking to 13 per cent.

With such a huge demand, it is obvious to replace the US with China in the oft-used phrase: “US sneezes, world catches cold”. With the Chinese economy slowing down rather abruptly, the effect is being seen across all industrial commodities. Aluminum price nearly halved in nearly three years as it currently priced $2,864 per kilo tonne as against $5,500 in 2013.Coal price which had hit $140  per CAPP unit in 2009, has declined to $43.33 on Tuesday. Copper price, the most important industrial metal, has crashed by 25 per cent in the last one year. From a peak price of nearly $650 per kilo tonne in 2013, it has touched $250 now — more than 100 per cent drop in the price.

Conspiracy theory about fall:  The fall of crude oil price is not just because of economics, at least some say. According to some conspiracy theories, the United States and Saudi Arabia have colluded to punish Russia for seeking a bigger say in world affairs by annexing Crimea and destabilising Russian speaking areas in Ukraine. While no one can prove this, history is witness to the effectiveness this strategy as the crude oil crash in 1980s had led to the dissolution of the Soviet Union, the second superpower of the day.

The low crude oil price will also potentially destabilise Iran, which considers the United States and Saudi Arabia its enemies. Another conspiracy theory which is floating around blames US President Barack Obama for the fall of crude oil price. Though it seems unbelievable, the conspiracy theorists believe that Obama wants to kill  the US shale oil industry as it could upset his ambitious green energy plans.

Sub-$30 worries Opec bloc: Opec president Emmanuel Ibe Kachikwu said on Tuesday that he expects an extraordinary meeting of the oil cartel in “early March” to address nosediving crude prices. “We did say that if it (the price) hits the 35 (dollar per barrel), we will begin to look (at)... an extraordinary meeting,” said Kachikwu, who is Nigerian minister for petroleum resources. The prices have hit levels that necessitate a meeting, he told an energy forum in Abu Dhabi, but added that he not yet confirmed with fellow Opec ministers if they would be willing to attend.

Meanwhile, Reuters reported that Opec has no plan to hold an emergency meeting to discuss the drop in oil prices before its next scheduled gathering in June, two Opec delegates said on Tuesday. On Tuesday, Nigeria’s oil minister said a “couple” of Opec member countries had requested such a meeting, after oil prices sank to a near-12-year low close to $30 a barrel. “There won’t be any meeting,” said one of the delegates from an African OPEC member country.
Lately, Saudi-led Gulf exporters within Opec have so far refused to cut production to curb sliding prices, seeking to protect their market share despite a heavy blow to their revenues. Mr Kachikwu said that member states differ on the issue of intervention. “One group feels there is a need to intervene. The other group feels even if we did, we are only 30 to 35 per cent of the producers really,” as 65 per cent of supply comes from non-Opec countries, he said at the Gulf Intelligence UAE Energy Forum.

“Unless you have this 65 per cent (of) producers coming back to the table you really won’t make any dramatic difference,” he added. US benchmark West Texas Intermediate (WTI) for February delivery was down around 2.8 per cent, at $30.54 per barrel, in Asian trade today. European benchmark Brent North Sea crude fell 3.1 per cent, to $30.57. The last time prices were so low for WTI was in December 2003 and in April 2004 for Brent. Prices plummeted 10 per cent last week on fears about the global supply glut and weakness in China, the world’s biggest energy user.