Sunday, 31 July 2016

Low Oil Prices Scenario

Historically, the OPEC, cartel of oil-producing nations, has been able to manage oil prices because of the lack of flexibility in global supply. And a small cut in OPEC supply can have a significant impact on the global oil price. 

This price surge started in around 2003 and reflects the persistent long-term growth of the key oil import markets of China and India. OPEC members produce 40% global proportion of oil with very low production costs. The key “swing producer” Saudi Arabia, has used its surplus capacity to influence price. The OPEC cartel is clumsy, given that some member states have an incentive to “cheat” by exceeding their authorized production quotas.

United States supplies of “shale oil” are said to be at risk once global oil prices fall below US$60 a barrel in terms of the current costs of existing operations or even US$90 a barrel in terms of investment in new projects.

US Shale Oil:
The advent of the US shale oil boom changed this dynamic. The industry has lower fixed costs but higher variable costs and is more like an industrial process than a major one-off investment. That makes it more responsive to price movements and more flexible in adjusting short-term output.

Overall though, shale is a relatively high cost source of oil, especially compared to Middle East production. As a result, when US shale threatened OPEC’s market share, the cartel allowed a position of global oversupply to develop to make oil prices fall to make shale unprofitable. Middle East production costs at as little as US$10 a barrel, while US shale can come in at more than US$70. The plan to cripple shale oil production has certainly had a significant effect. The price has fallen from a high of US$115 a barrel in mid-2014 to a low of US$27 in January 2016.

Why haven’t US producers been laid low given that the oil price has already fallen below the cost of shale oil production? The answers are:The first is that many companies managed to hedge their production when prices were higher, selling future supplies of oil at a high enough price keep profits coming in. A second is that many got bank loans to pay for investment. Loans need to be repaid, and so lower oil prices led to a need for higher output at almost any price. A third, and important reason, is that the cost of US shale production has decreased due to efficiency gains and production costs got reduced costs to as low as US$30 a barrel.

Russia Pressure:
Oil exports account for over 60% of export revenues, on average, for OPEC countries and account for as much as 90% of Saudi budget revenues. In Russia they account for around half of total federal budget revenues and a similar amount of total exports. Any fall in prices can lead to both fiscal and budget deficits. Russia looses about $2 bn in revenues for every dollar fall in the oil price, and its economy would shrink by at least 0.7%.

Despite pressure, the gap between breakeven and actual price can be sustained for a while. Both Saudi Arabia and Russia have built up significant currency reserves during the period of high prices which are now being used to finance a budget deficit and sustain spending. Russia is reaching the limits of its reserves getting exhausted by early 2017. Currency devaluation is a blunt tool for Russia and others to consider to reduce costs in dollar terms.

The bankruptcy of US oil producers has begun as banks begin to call in loans, new financing gets harder to find and hedging programmes expire, leaving producers fully exposed to a lower oil price. Many OPEC countries have begun to despair that no end of the current oil price slump is in sight. It appears that Russia is becoming increasingly desperate to coordinate a production cut with OPEC, in stark contrast to its previous reluctance to engage with the cartel. 

A US$30 oil price has brought many producers to their knees, with the resulting possibility that the majority of OPEC countries, plus Russia and the US, may all be set to reduce output in 2016 and bring the oil market back into some form of balance. Only Saudi Arabia, with the largest financial reserves (about US$600 billion) and an avowed strategy to maintain market share, appears firm in its resolve to maintain production and brutally test the economic robustness of its major competitors.

Low oil prices impacts Gulf states:
  • Analysts expect oil prices to remain depressed for the remainder of 2016.
  • In 2014, after almost a decade of record highs, the price of a barrel of Brent crude began to collapse from a peak of US$140 to less than US$30.
  • Saudi Arabia is lining up a US$2 trillion sovereign wealth fund to see it through the twilight years of the oil era. But not all the countries of the Gulf Co-operation Council, or GCC, have this kind of cash. 
  • Even for Saudi Arabia, the new era of low oil prices spells increasing budget deficits, reductions in state subsidies and a slowdown of the energy and construction sectors.
  • Bahrain is still coming to terms as subsidies fall and inflation rises, people living and working in the region are starting to experience a reduction in the purchasing power of their incomes and increase in the cost of living.
  • If the price remains low, reserves also will start to run out in two or three years.
Low oil prices impact on India:
  • Current account balance:
    India imports nearly 80% of its total oil needs which is one third of its total imports. A fall in oil prices by $10 per barrel helps reduce the current account deficit by $9.2 billion or 0.43% of the GDP.
  • Inflation:
    Because of use of oil in transportation of goods and services and fall in global crude prices decrease in prices of all goods and services thus helps reduction of inflation. Every $10 per barrel fall in crude oil price helps reduce retail inflation by 0.2% and wholesale price inflation by 0.5%.
  • Oil subsidy and fiscal deficit:
    The government compensates oil companies for any losses or under-recoveries from selling fuel products at reduced rates resulting in higher fiscal deficit. A fall in oil prices reduces companies' losses, oil subsidies and thus helps narrow fiscal deficit.
  • Rupee exchange rate:
    A fall in oil prices is good for the rupee. But the dollar also strengthens every time the value of oil falls. This negates any benefits from a fall in current account deficit.
  • Petroleum producers:
    The fall in global oil prices affects the exporters of petroleum producers in the country. India is the sixth largest exporter of petroleum products in the world earning $60 billion annually. India's buyers of its exports are net oil exporters and fall in oil price impacts their economy, and hamper demand for Indian exports.
  • Remittances from abroad:
    Indians remittances from abroad, mainly Gulf, were $70 billion in 2013 thus reducing current account deficit.  Fall in oil prices affects oil-exporting Gulf countries and in turn affects inward remittances into India.

My View:
Oil prices at moderate levels of $50-70 is good for economic stability of the world. Either high or low oil prices hurts some nations while doling out windfalls to others.

India is immensely benefited in the last two years by saving at least Rs.500,000 crores worth in foreign exchange outflow reducing the impact on fiscal deficit, trade deficit and inflation under control, even though inward remittances from Gulf had reduced to some extent. Ruthless Modi govt retained all the benefits of low oil prices by increasing duties on petrol & diesel to alarmingly high levels making them most expensive in the world. While UPA Govt made consumers pay international market prices during high oil price regime for nearly 10 years, Modi & Jaitley though fit not to pass on benefits of reduced oil prices to consumers. This is nothing but taxing public without legislature approval and is unethical as well as immoral.

However negative effects of prolonged low oil prices will be felt here after, mainly Indians in Gulf region losing jobs and returning to India. Already diminishing exports are hurting trade deficit even though imports have also reduced to some extent.

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