The consequences of declining oil prices

There’s a lot of attention currently on falling oil prices. Today oil prices dropped below 66 dollar, at the fastest pace since 2010. One recurring theory we hear is that falling oil prices are aimed at hindering the Russian economy. Despite being a conspiracy theory, this can be considered a reassuring theory, because it would indicate that the Western world has control over oil prices. The theory implicitly assumes that there are no real limits to oil production, as OPEC nations can simply ramp up production to harm competitors if need be.

There are a number of issues with this explanation. It’s questionable whether OPEC nations would really be willing to risk harming their own economies in an effort to attack Russia. OPEC nations are plagued by domestic instability and depend on high oil prices to manage their budgets. At 70 dollar a barrel, practically all OPEC nations are dealing with budget deficits. It’s hard to believe that they would cooperate to crash oil prices, despite facing domestic instability likely to be exacerbated by collapsing oil revenue.

The effect of low oil prices on the Russian economy are also likely to be overestimated. Russia has an estimated 2 trillion dollar worth of capital reserves it can burn through, as well as a very low debt to GDP ratio. Western critics of the Russian regime like Bill Browder exaggerate the effect that low oil prices has on Putin’s regime, fostering the illusion that this is all part of an orchestrated plan.

It’s also highly unlikely that the United States government would benefit from such a hypothesized conspiracy against Russia. US shale oil companies have entered large debts that can only be paid back if oil prices remain elevated in the near term, as shale oil wells show very rapid decline rates. The shale oil companies face a significant risk of insolvency in the near term if oil prices don’t recover rapidly, for which there is no reason to assume it’s going to happen.

There’s a simpler explanation, which would suggest that we’re facing a significant period of crises in the coming years. Instead of oil prices crashing because of excessive production or puppet-masters behind the scenes, oil prices have remained at an unsustainable elevated level for the past few years, as a result of speculation on further price rises in the future due to rising extraction costs.

To understand what’s going on, we first have to establish that oil prices do not appear to follow a random walk, as multiple studies have argued.2 The random walk hypothesis came about to suggest that it’s not possible to reliably predict stock market fluctuations in advance, as the fluctuation is effectively random. In the case of oil, the drop in prices from 140 dollar to about 45 dollar per barrel within a period of months suggests that the market is not efficient.

Since 2002, the commodity markets have increasingly fallen victim to investors, who use leverage to bet on ever increasing prices. This has contributed to enormous volatility on the markets. In part this can be attributed to central bank policies, as the markets face a search for yield. If government bond yields are at record low levels, investors have to search for a profit elsewhere, which makes oil, as well as gold and other commodities very attractive. An IEA analyst among others warned of this risk back in 2010.3

The problem emerges when speculators become unable to maintain their leveraged positions, but it’s hard to predict in advance at what point this happens. We now appear to have reached this point. Not just oil prices are falling rapidly, but copper prices are simultaneously dropping a lot as well. Reuters reported that hedge funds held 15 barrels of oil long for every barrel they held short in October of 2014.4 This is indicative of a speculative bubble. Because speculators are trading with speculators, the price became detached from reality.

Speculators made the mistake of assuming that consumers would at some point step in as a result of an economic recovery increasing their consumption level. This has not happened, as global GDP growth is not meeting the expectations economists had, especially in China. In addition, soaring income inequality means that although the situation for regular citizens has not improved, a small elite has seen their income grow tremendously. Between 2009 and 2012 the bottom 99% of Americans saw their incomes rise by 0.4%, while the wealthiest one percent saw their incomes rise by 31.4%.5 As a result there is not enough demand for oil and prices go down, while stocks can continue to surge.

In the past few years, there has been a growing discrepancy between the price of oil that consumers can afford and the price of oil that producers need. Speculators stepped in and bridged this gap, but speculators at some point have to sell the oil back to genuine consumers, who never became able to afford these high prices as a result of the absence of any real increase in their income. Prices are now rapidly dropping to a level that consumers can afford.

There are a variety of problems that we can expect to result from this. The first and most obvious problem is that oil companies in the US won’t be able to expand and eventually not even able to pay back their debts. Oil exporting companies will find themselves facing growing budget deficits, or alternatively, forced to cut back on expenses. Even for oil consuming countries, the current situation poses severe problems. Taxes on fuel are a significant source of revenue, hard to avoid for citizens. In Europe, low oil prices may exacerbate the growing risk of deflation.

The country that would be expected to suffer the brunt of the consequences is the United States, as rising oil production and the economic activity that accompanied this has been what helped the nation stay out of recession. Due to the high extraction costs, economic activity surges drastically as well when shale oil production grows. A barrel of tight oil that costs 70 dollar to extract will produce more economic activity than a barrel of oil that costs 2 dollar to extract.

Predictions of rising oil production until 2020 are cast in doubt by the current low prices. It’s known that besides exacerbating inequality, quantitative easing carries the risk of causing resource misallocation in the economy, of which the tight oil boom appears to be one expression.

The question that we have to ask is why no major established oil companies seem to show interest in the unconventional oil business. These are companies that have massive research departments with the brightest minds you will encounter and yet they don’t participate in this boom. In 2013, Shell abandoned its shale project in the United States.6 Chevron threw in the towel back in 2012. What is it these small indebted companies figured out that Chevron and Shell can’t? With oil prices plunging below seventy dollars, we’ll soon find out whether these emperors forgot to bring their clothes.


1 – http://www.reuters.com/article/2014/08/01/russia-reserves-idUSL6N0Q70OV20140801

2 – http://natagri.ufs.ac.za/dl/userfiles/Documents/00002/1870_eng.pdf

3 – http://blogs.reuters.com/great-debate/2010/10/29/quantitative-easing-and-the-commodity-markets/

4 – http://www.reuters.com/article/2014/11/17/oil-prices-hedgefunds-kemp-idUSL6N0T72E320141117

5 – http://blogs.wsj.com/economics/2013/09/10/some-95-of-2009-2012-income-gains-went-to-wealthiest-1/

6 – http://fuelfix.com/blog/2013/09/25/shell-pulls-out-of-oil-shale-project-leaving-1-big-operator-behind/

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