The destabilizing effects of lower oil prices
The oil cycle has peaked after sustained high prices made large volumes of new oil production economical to develop.
An underlying market imbalance has arguably existed for two years but was masked by temporary production outages in Libya and other countries. While the return of Libyan production in June 2014 coincided with the Islamic State's attack on Mosul, the many and continuing geopolitical risks were soon overshadowed by the realities of weakening fundamentals. By December, the US benchmark West Texas Intermediate was trading at five-year lows.
Compounding the oversupply issue is the Organization of Petroleum Exporting Countries' (OPEC's) November decision to maintain current production for now, even as its own balances suggest the need for a substantial production cut. The cartel still holds the potential to roil markets with a cut, and its sudden embrace of the free market to solve the supply issue is inherently destabilizing not just for markets but for the industry and national economies. IHS believes this price decline is not finished, and volatility will remain well above the low levels of 2013 and early 2014 (see figure).
With OPEC set to maintain production levels for the near term, the best chance for halting the price decline will likely come from US shale oil producers-as declining production rates from new shale oil wells, and a reduction in investment and drilling, will make it difficult to maintain prior growth levels. On the other hand, while drilling permits and capex plans have been cut, factors such as hedging, known sweet spots, and improved techniques such as super fracking will make US shale oil partially resilient to low oil prices-at least for a time.
Lower oil prices also create challenges for some OPEC countries and other big exporters-particularly those with weaker fiscal circumstances-as their revenues and foreign-exchange reserves decline. This may force cuts in social spending in some of these countries, increasing unrest and potentially causing production outages, which in itself would quickly increase prices.
A positive impact of lower prices is cheaper fuel for consumers. While this will not translate directly into increased oil demand, it will help boost economic growth, the key driver of energy demand. Many consumers, mindful of price swings since 2007, will likely be slow to make lifestyle changes to fully take advantage of lower prices.
The destabilizing effects of a lengthy downturn could continue for many years as consumers and companies find their footing in this new era. Eventually, however, reduced investment in long-lead projects will create much tighter balances, leading to substantially higher oil prices.
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