Friday 9 December 2016

Be careful what you wish for when it comes to a sustained oil price low

Published 03/09/2015 | 02:30

Continuing to pay less at the pumps shouldn’t necessarily fill us with joy
Continuing to pay less at the pumps shouldn’t necessarily fill us with joy

It has been one of the biggest economic surprises in many years. Just four years ago when Ireland was in the depths of the biggest post-crash recession, we were paying €1.63 per litre of petrol at the pumps.

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Oil prices were surging ahead to over $130 a barrel having almost doubled in the previous 12 months. It looked like oil prices were no longer part of any great economic cycle but were simply going to keep going up.

But that all changed last year when prices collapsed from $110 a barrel to around $55 in the space of just a few months. Concerns about China's demand for oil, the impact of fracking mainly in the US and wider economic concerns have kept oil prices low. The question is how long will that last?

For oil importing countries like ours, we might think it is a case of the longer the better. We are paying an average of €1.43 per litre of petrol which is a boost for consumers and business that is helping the economy to grow.

Some experts now believe these lower prices could remain in place for up to five years before a genuine spike occurs again. A three-day oil price rally earlier this week, looks to be fizzling out again and prices retreated. Some believe they could fall further.

Here are some of the reasons why:

The Chinese slowdown means its oil demand will be flat this year and only increase a little next year and in 2017.

l With sanctions dismantled, Iran is expected to slowly increase its output and could add about one million barrels per day to production within two years.

l So far Saudi Arabia has shown no interest in cutting production in order to boost prices. It has $500bn of reserves and unlike smaller oil-producing countries it can absorb lower prices for some time. If the Saudis changed their minds, prices would rise.

While lower prices have provided an economic boost at a crucial time in countries like Ireland, and we might wish they would last forever, the implications of prolonged lower oil prices could be enormous in other countries.

Russia: A combination of sanctions and lower oil prices has decimated the economy, currency and exchequer finances. Interest rates are running at 11pc. Inflation is at 15pc. The exchequer can balance its budget when oil prices are at $105 a barrel. Brent Crude is now at $48. Russia's foreign currency reserves have dropped by about $140bn since January of 2014.

Nigeria: Economic growth has shuddered from 6pc a year ago to around 2pc. Africa's largest economy has devalued its currency twice in the last year. Around 90pc of Nigeria's foreign currency earnings come from oil. Nigeria needs oil prices of $119 a barrel to balance its budget. In recent weeks the government has resorted to chopping down trees lining the streets of its capital to thwart black market money changers who had used them as cover for selling foreign currency.

Brazil: Inflation is running at 10pc. Petrobas, the country's biggest oil producer, saw its profits fall by 90pc in the second quarter of this year. The company has $124bn in debt and faces multi-billion dollar fines from a corruption scandal. Brazil relies on oil revenues to fund education and infrastructure projects. The economy will contract this year and it is paying an interest rate of around 11pc on its sizeable national debt.

Venezuela: The country has probably been the worst hit by the oil price fall. Inflation is running at around 772pc per year and its currency shed 32pc in July alone. Default on sovereign debt now looks likely.

The United States: Fracking delivered a massive oil boom for the US at a time when the country needed the economic injection of cheaper fuel and greater oil exports. The collapse in oil prices has hit the fracking business very hard. Around 80,000 fracking jobs have been lost. Production has fallen dramatically but investment has dropped off even more.

Now the frackers are talking about the concept of "re-fracking". This is where they go back to an abandoned well and frack it all over again. The technology is not fully proven but they see it as a way of extracting every last drop out of previous wells, but without the massive capital investment of starting a new well. Nobody knows for certain what the break-even oil price is for fracking companies but the industry itself has suggested that at least 40pc of fracking operations are losing money at current oil prices.

The US has built up crude oil stocks which have hit their highest levels since 1982. This means any increase in demand due to economic recovery could take time to be reflected in the oil price because of large inventories. Oil projects are being postponed. Major oil companies are slashing costs and holding off on investing money. We have seen it with Irish companies like Tullow Oil which has slashed costs. It will have implications for investment in Irish offshore oil projects where the international appetite for higher risk and more expensive drilling is curtailed because the risk/return equation is out of kilter.

Sustained low oil prices have other implications too such as the impact on sustainable energy projects. Wind and solar energy projects cost governments money and they might see them in a less favourable light if oil prices remain low.

They shouldn't of course, because even four or five years of lower oil prices will not diminish the need for longer term sustainable energy solutions. When oil prices began to tumble in 2014, shares in companies as diverse as electric car maker Tesla Motors, wind energy companies and solar panel manufacturers began to tumble too.

Over the last 18 months they have regained some of that ground as the longer term investment case remains. But we are seeing some governments step back from wind power, in Britain, Germany and Ireland. Back in the oil crisis of the 1970s the Jimmy Carter government in Washington put solar panels on the roof of the White House. With the crisis over in the 1980s, Ronald Reagan had them taken down.

When oil prices fall, the short term mathematics around sustainable energy solutions changes, even if the long term investment case remains.

We don't see the full extent of oil price falls at the pumps because of government taxes and in particular the way excise charges are structured. Nevertheless, when Brent Crude was at $55 a barrel in February, average petrol prices here hit a low of €1.28 per litre. With Brent under $50, we may see a further reduction coming through to the pumps in the weeks ahead.

A sustained low oil price might be just what consumers and businesses in Ireland would wish for. But the reasons behind any sustained global oil price low might not be good for an open economy like Ireland's after a year or two. We should be careful what we wish for.

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