Cheap oil's great, except when it's a nightmare: Marc Champion

by: AdminFri, 25 Dec 2015

LONDON (Bloomberg View) -- Brent crude hit an 11-year low of $36.20 on Tuesday, in part because OPEC has ceased to function. So, ding dong, the cartel is dead. By all means sing and ring the bells out. Just not too loudly.

This isn't, of course, the first time that oil prices have suddenly taken a tumble. Nor would the Organization of Petroleum Exporting Countries be the first oil cartel to go limp. So we -- or at least the energy guru and Pulitzer prize-winning author Daniel Yergin -- know something about what to expect.

Quick Take Cartels

In the short term, the answer is straightforward and zero- sum: Cheap oil is good for growth in consumer economies and bad for producers.

That picture may be more complicated for the U.S. this time, Yergin says, because it only imports about a quarter of the oil it consumes today. That's down from 60% in 2005, before the shale oil revolution really took hold. Equally, much of the job growth in the U.S. in recent years has come from expansion of the shale industry, now endangered by lower-priced imported oil. "Unwind that job creation and you have a real problem," Yergin says.

Even without this change, though, there would be reason to think hard about how the sudden wealth transfers that extreme oil-price volatility causes will pan out over time. OPEC has rarely been a well-meaning price regulator and was often ineffective; today it controls only about a third of oil output and may not even qualify as a cartel. But an arrangement that truly smoothed out price volatility would be beneficial, even though that would mean higher prices, for example, now. That's imaginable through the creation a "good" cartel, or governments disciplined enough to raise and lower gas taxes to offset oil's fluctuations, steadying demand. Each, however, is about as likely as a visit from the real, real Santa.

For oil-consuming countries, low crude prices act as a free tax cut, but they also drive down investment in future output. Capital expenditure in oil gas extraction tends to track the price of oil pretty closely:

When demand bounces back or there's a supply shock, glut can turn abruptly to shortage and prices can rocket upwards, triggering recession. Think 1973. In that year, OPEC imposed an oil embargo in response to U.S. involvement in the Yom Kippur war and the oil price quadrupled. Annual U.S. growth declined from 5.6% in 1973, to minus 0.5% in 1974. Says Yergin: 

That was a dramatic example, when oil markets were tight, demand was strong, a crisis occurred and the oil price exploded.

Prices then fell back in the 1980s and remained low for years, changing expectations and investment appetite:

As late as 2003, institutional investors were urging oil companies to exercise what they called capital discipline. They were saying: 'don’t invest heavily, because oil will be at $20 forever.' Then the very next year prices began their explosive rise. That was because people had been investing for a $20 world and then demand took off, led by the double digit growth in China.

IHS, the consulting group of which Yergin is vice chairman, projects that oil companies around the world will invest $600 billion less in developing new production between 2015 and 2020 than it had been forecasting in 2014, before the oil price began its decline. That's a lot of cancelled investment and capacity.

This would be great for climate change policy if all the forgone investment shifted to renewables, but it probably won't, so prolonged low prices and investment in oil capacity runs similar risks today.

For producer countries, many of which are overly dependent on oil revenues, low prices tank the economy, slash budgets and can produce political instability. When those countries are opponents of the U.S. -- such as Russia, Iran or Venezuela today -- that can be another reason to celebrate (low oil prices contributed to the collapse of the former Soviet Union, after all). But it doesn't always work out well.

An oil-price slump in the 1980s, for example, was one of many reasons why Saddam Hussein invaded Kuwait, with all the ramifications that has since had for regional stability and the loss of U.S. blood and treasure. Saddam had ended his 1980-1988 war with Iran owing about $37 billion (much more by some estimates) to Kuwait and the other Gulf States. Even today, Iraq gains 93% of its budget from oil revenues, so when the oil price fell from over $100/bbl to settle below $40 by the mid-1980s and mainly stuck, Iraq's government was badly hit.

As Yergin describes in his most recent book, The Quest, Saddam summoned the U.S. ambassador a week before invading to complain that Kuwait was pumping too much oil, forcing the global oil price down. By invading Kuwait, he sought among other things to eliminate part of the debt, secure new revenues and turn Iraq into a second Saudi Arabia.

Venezuela's economy was struck by the same oil-price slump. The economy contracted sharply and then flat lined for a decade, inflicting economic pain on much of the population. Former President Hugo Chavez is more often regarded as a beneficiary of the long oil-price rise that followed his election in 1999 -- much like Russia's Vladimir Putin, who came to power at the same time. But according to Yergin it was another oil price collapse in 1998 that "set the stage" for Chavez's election.

So whom should we worry about today? One country is, again, Iraq. Already politically fragile, the International Monetary Fund warned this summer that Iraq faces two existential threats: Islamic State and a falling oil price. A Syrian-style implosion is only too easy to imagine.

Russia has coped relatively well by allowing the ruble to fall with the oil price, broadly maintaining public finances. But if oil stays at $40 or below for a number of years, that may not be enough. It is hard to predict how Putin -- who had great success consolidating political support in the face of a weakening economy by attacking Ukraine -- would respond to economic meltdown.

Nigeria, a country of almost 180 million people that's also battling a terrorist insurgency, Boko Haram, is getting hit especially hard; energy accounts for 35% of gross domestic product and 90% of exports. On Tuesday, President Muhammadu Buhari asked parliament to adopt a budget 20% larger than last year's to stimulate the economy, paid for by new borrowing. Even if that's smart policy, it's a sign of desperation.

OPEC may well be on its way out. It is the third global oil cartel that has sought to control the commodity's supply and thereby its price: The Texas Railroad Commission regulated output at a time when the U.S. dominated oil production; the "Seven Sisters" oil companies also formed a cartel to carve up resources and control prices. None is missed. When it comes to low oil prices, though, we should be a little careful what we wish for.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.


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