The falling price of oil continues to dominate global energy news. By mid- January, the price of crude had fallen below $50/bl for the first time since the depths of the global recession in 2009.
Why has the price plunged so dramatically? The short answer is that a combination of slackening demand and rising supply created a glut.
Demand seems to have been hammered by China’s rapidly cooling economy – after all, the Asian giant has been responsible for about half of new oil demand in the past few years – as well as continued stagnation in Europe. But demand has hardly collapsed as it did when world trade contracted by a quarter in early 2009.
The main supply-side factor is the surge in US shale oil production, which was virtually zero in 2008 but has gradually ramped up to over three-million barrels a day.
But market speculation also plays a role and can amplify price swings that are triggered by fundamentals. Once the market builds up momentum, expectations that the decline (or rise) will continue become a self-fulfilling prophecy. It seems that key members of the Organisation of the Petroleum Exporting Countries, or Opec, such as Saudi Arabia, have been actively talking the price down, fuelling suspicions that they are trying to derail the shale oil juggernaut or punish geopolitical adversaries Iran and Russia.
Speculation aside, the economic repercussions of the price rout are increasingly evident. Oil exporting countries are hurting, with many of their governments having come to rely on oil prices near $100/bl to balance their Budgets. Venezuela’s President Nicholas Maduro is at pains to convince funders that his country is not about to default on its debt, while Russia’s Finance Minister has acknowledged how his economy is bleeding.
But, for much of the world, falling oil prices are usually an economic blessing. Cheaper transport fuels raise real disposable incomes, take the pressure off inflation and may actually bring down prices of goods, like food, in absolute terms.
On the other hand, some commentators are worried that falling prices could be the greater of economic evils for the eurozone, which is dabbling with deflation. Deflation is dangerous because consumers can rein in spending on the expectation that goods and services will become cheaper in time, creating a vicious cycle of demand contraction and recession. Further, businesses facing falling demand seek to cut costs by laying off workers, which, in turn, reduces household incomes and demand. Meanwhile, the real value of outstanding debt increases and so a larger fraction of household, corporate or government income has to be allocated to debt repayments. In the worst case, these forces could coalesce into a debt- deflationary spiral.
Another risk presented by the falling oil price relates to Wall Street’s latest lending spree, which has been creating junk bonds for companies drilling for shale oil in the US. Oil analyst Arthur Berman has calculated the shale breakeven price as $80/bl to $85/bl and points out that recent oil company financial statements paint a dismal picture. In the short term, they have to keep producing to honour contracts, but their cash flow is drying up. Should these firms default on their loans, it could trigger another systemic financial crisis.
These complications suggest that the world economy may be damned if oil prices are high (by suppressing demand) and damned if they are low (by creating systemic financial risks).
Underlying this apparent contradiction is the fact that the energy landscape has fundamentally shifted in recent years. Conventional oil production has stagnated since 2005, and the oil industry has had to scour the globe for higher-cost unconventional oil resources in deep-water offshore fields, shale basins and tar sands. The resources are there – for the time being at least – but the cost of bringing them to market is higher than debt-laden consumers can bear.
Several years of triple-digit oil prices have put serious strain on oil importing economies, dragged down world growth and exacerbated debt and balance of payments problems. Put simply, without cheap energy, the global economy cannot grow fast enough to reduce debt levels.
We are already seeing falling rates of shale oil drilling and declining investments by major oil companies, which sets the stage for a decline in supply and a recovery in oil prices in a year or three, just when demand could start to pick up again.
This cyclical pattern of high oil prices, demand destruction, falling oil prices and partial economic recovery leading again to higher oil prices, and so on, is exactly what peak oil commentators started warning about a decade ago.
The centrality of energy – and, more specifically, oil – as the master resource propelling the world economy is something missed by most of mainstream economics, which explains why the endless debates between deficit spending advocates like Paul Krugman and his pro- austerity ideological adversaries ignore the elephant in the room.
In South Africa, by contrast, we are keenly aware of how energy constraints – in our case, insufficient electricity – hobble the economy.
The solution to the conundrum lies in a twin approach of increasing energy efficiency and accelerating the transition to sustainable energy sources.