Thursday, October 30, 2014

Impact of lower oil prices -- its not all good, right?

First off, understanding the impact of dropping oil prices is complex, because the law of unintended consequences applies.  There is no doubt that falling oil prices is good for business and good for consumers.  Because it increases, directly, income (and profits), so the impact at first blush is positive.  At the end of the day, the impact of oil price drops is good in terms of inflation expectations (down) and to growth to the economy.

The fall in oil prices is caused by a change in the supply demand equation (either figure can shift):

  1. First, the supply picture has changed enormously over the past decade.  In 2004, fractioning margin (refining process) carried negative price.  Oil company could not pass on the cost (necessary) of refining the oil they produced.  The impact was under-investment that has translated into compressed supply (at the very least limited search for new oil reserves).  The massive boost in price from $35/bbl to $100/bbl had the obvious impact on supply -- it rose. America today produces more oil and gas than it did at any other time (we are going back to the 1950s here!!!).
  2. Demand has shifted over the past few months.  Starting in 2013, Europe's growth started to falter -- the periphery first (not talking about Greece here) but now more central with France and Italy in recession and now even Germany feeling the impact.   Japan's experiment with "new economic theory" is failing (spectacularly) with both consumption and income dropping, and China is finally facing the reality of large numbers -- its a lot harder to grow at 10% when you are the world's second largest economy.  So growth everywhere is slowing. 
The juncture between supply (that has risen) and demand (that has slowed) is for marginal price to drop -- oil supply is, in the short term, very inelastic.  So prices dropped from 105 to 80 in 160 days!  

Now, for producers (especially the new guys on the block -- like Shale oil) the $80 price is bad news, because extraction cost are high.  At $105 this was a profitable endeavour, at $80.89 (price of WTI light and sweet) the price of synthetic oil (which is what is produced by shale oil) is much lower, and the break-even level is close by -- some would say that break even is around $85/bbl. 

That means less exploration -- no doubt that fields are that are already operating will keep on going but new stuff will be delayed -- that will result in a future shift in the supply complex.  

For producing countries that situation is entirely dependent on where they stand in the price complex. Saudi Arabia -- considered the cheapest producer at $20/bbl has the most latitude -- they have recently reduced production -- keeping their oil in the ground for when price rise again (banking into the future the profit from sales).  But for countries like Venezuela the drop in oil prices is nothing short of catastrophic.  Their oil revenues are fully spoken for in terms of government expenditure.  Venezuela one of the largest producers in the world is facing massive dislocation.  Canada is a middle ground player.  With oil sands and classical oil (less now), but the new finds are expensive -- news should transpire soon on "delayed" projects.  The impact on those economies could be important.  After all, its their core growth that is affected.

For Canada, a weaker economy and a weaker currency -- will be harsh on Canada's 2014/15 prospects.  But and this is important the global commodity market is in a slump, and has been for the past 12 months.  Since about 1/3 of Canada's economy is ressource driven... its a problem. Politically, its also a problem for the sitting government that will see election in Q2/2015 -- by law!  It may be tempting (despite the recent poor polling) to go a get a new mandate before the economy slows more dramatically.

For renewable energy, the drop in oil prices is bad news.  Because people always look at the option of choosing renewable energy Vs. oil&gas with the low price point as a reference guide.  Solar energy that was 10 years ago, prohibitively expensive is now cheap enough to be roughly comparable to oil & gas, but only when oil is around $100/bbl.  Some would say that the world has moved so far along the renewable side of the equation that a short term shift in oil price will not really alter people's long term energy generation decision... maybe, but again its far from certain that the same kind of capital will be deployed for renewable energy when oil prices are in the $70/$80 zone rather than the $95/$110 zone.

That's the law of unintended consequence, the impact of renewable energy, the reduction in green gas emission will be further delayed...

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