Crude Oil

Price Stability vs. Market Share

Bennet Kpentey, an Accra, Ghana management and financial consultant with a focus on the oil, gas, and energy sector, shares his views on the strategies of maintaining and increasing crude oil production and how the volatile energy prices will affect growth in emerging economies and other industries.

The past six months have witnessed a precipitous drop in oil prices.  From a high of US$107 a barrel in June 2014, prices have plunged by some 50% to a five-year record low of US$54 per barrel in December 2014—which is still falling.  A look at the recent history of oil price movement shows that apparently this is actually the fourth steep drop in the past thirty years.  The first such cycle was experienced in 1986 when prices dropped to below US$10 per barrel.  The second occurred twelve years later in 1998 when prices dropped from over US$13 to US$9.94 per barrel, the lowest in the preceding twelve years.  The third precipitous drop happened in 2008 when prices fell from US$145 to US$33 per barrel over a six-month period, triggered by the financial crisis and steep decline in global demand.

 

So what happens when oil prices take a nose-dive?  Experience and history shows that a fall in oil prices is welcome news to almost all non-oil sectors and consumers.  However, because this is bad news for oil-producing countries, the general fear of analysts always materializes in a cutback of production by the Organization of Oil Exporting Countries (OPEC) members to stabilize prices at a relatively higher level.  Production cuts, the main strategy used to maintain higher prices, was expected to have happened as current prices have fallen below the break-even prices most oil-dependent countries.

 

Oil prices below US$80 are devastating to most oil producers because they require prices above US$100 per barrel to balance their budgets.  It was therefore generally anticipated that OPEC would agree to cutback production to maintain higher prices.  To give examples, Saudi Arabia needs a price of US$100 a barrel to balance its 2015 budget.  Others are as follows: Venezuela (over US$150), Algeria (US$132), Iraq (US$116), Iran (US$131).  Nigeria has cut back its 2015 budgeted price expectation to US$55 a barrel.  Norway’s oil industry has suffered significantly from the prices and is expected to fall on its US$870 billion Oil Fund—built up over the last 18 years—to meet government budgetary requirements.

 

When the OPEC members met on Thanksgiving Day on November 27 2014 in Vienna, Austria, they surprised the market and non-OPEC members by agreeing not to cut production levels.  But why not if that would reverse the falling prices?  An understanding of why OPEC is not cutting back production for prices to fall to such low levels takes us back to the factors accounting for the current drop in prices—the waning threats by Russia to disrupt prices due to sanctions, economic slowdown in Europe and Asia, and most importantly the surge of shale oil production in the U.S. (U.S.) through the process called fracking.

 

The combination of these factors triggered a fall in global demand for oil.  Of particular importance is the surge in oil production in the U.S. over the last three years.  This has brought a new reality to the global mix.  The oil exporting countries have lost their share of the U.S. market planned for 2014 and beyond.  Indeed, through fracking, the U.S. profoundly changed the geopolitical configuration of the oil industry by becoming not only the world leading producer of oil, but also a net exporter of oil.

 

For OPEC members and the other leading oil producers, this is not good news.  And they are not ready to entertain another competitor.  One can begin to appreciate the strategy of OPEC: to allow prices to fall to the level that will undermine the economic and commercial viability of the rising industry in the U.S., which are known to have higher than the average production costs in the Middle East and other regions.

 

Saudi Arabia, the world leading oil exporter, and its Gulf allies therefore convinced OPEC members to maintain planned production targets due to the risk of losing market shares to non-OPEC members including the U.S. should they cut back production.  Saudi Arabia has, for example, deepened discounts to the U.S. and buyers in Asia in order to maintain its market share.

 

When shale oil fracking picked up in the U.S. on the back of high crude prices, over the last five years, it was hardly expected to transform the oil industry geopolitical landscape.  There were strong protests by environmentalists due to the serious negative implications associated with fracking.  However, the strong quest to reduce the U.S.’ dependence on crude oil from the Middle East, a region that has seen an escalation in political and social disturbance, offered strong reason to go “fracking” and overlook the destructive environmental implications.

 

And the growth of the U.S. shale oil industry has been astronomical in the past five years.  In 2009, for example, U.S. railroads transported 21,000 barrels of shale oil a day.  Today, they carry 1.1 million barrels of shale oil a day according to data from a federal regulator, the Surface Transport Board in the U.S.

 

One thing is certain. OPEC members should be ready to go the long haul because the shale and oil sands industry in the U.S. does not have a uniform cost structure.  It is a diversified industry with several producers operating with different cost structure and price expectations.  There are several plants with huge sunk costs that will not be severely hurt by short-term low prices, only there will be a hold on future investments in infrastructure and expansion plans.

 

Generally, however, the shale producers in the U.S. are continuously lowering cost through innovation and technology.  They can only be hurt should prices remain low over a long period.  But the Saudi-led strategy is actually beginning to bite the U.S.  Alaska, for example budgeted with an oil price of US$80 in 2014.  As a result of the low oil prices, Alaska’s GDP contracted by 2.5% in 2014 with a budget deficit of about US$2 billion.  Louisiana had an oil revenue shortfall of about US$200 million in 2014, which affected its budget negatively.  While Texas has survived so far, the answer to the quest as to how long it can continue to braze low crude prices appears to be certain.

 

What does this mean for short-term oil prices?  With OPEC’s quest to reduce competition and maintain its market share, oil prices are likely to stabilize at relatively lower levels in the short-term, at least for the next one year.  Saudi Arabia has been resolute in maintaining the current production levels even if that should mean a fall in prices to US$20 per barrel.  Saudi Arabia and its Gulf allies expect the oil price to stabilize around US$60 a barrel.  At this price, they expect to maintain their market share.  Kuwait for example is basing its 2015 budget on a price of US$55 to US$60 per barrel.

 

What are the implications for the world’s economy?

Falling crude prices is always seen as good news that bring enormous relief to consumers because low prices are expected at the pumps. Low oil pices stimulates consumption and demand, triggers production and eventually boosts economic growth. Experience from the three previous oil price collapses in the last three decades all showed global economic turnaround. So given the odds, the world economy is expected to see a turnaround on the back of the current low oil prices.

 

But falling oil prices, especially at the current levels, can bring economic downturns.  Both the OPEC and non-OPEC members that rely solely on oil revenues are in big trouble.  Ghana recently joined the league of oil-producing countries with expansion plans through the Tweneboa-Enyenra- Ntomme (TEN) oilfields, expected to generate more oil revenues to support the national budget and economic growth aspirations.  However, low prices are putting a stranglehold on expected revenues from this fossil-based sector.  This is a big blow that will undermine expected investments to develop production fields.

 

Venezuela, an oil-dependent country, went into a recession in December 2014 as a result of the low oil prices, acknowledging that other factors such as socio-political instability contributed to this.  The hurt triggered by the low prices will not end at country level.  It will affect most oil-based industries, with major companies expected to experience low bottom lines with gloomy results.  Firms in Norway shed some 10,000 oil sector jobs by October 2014.  This is also affecting equity markets as has already been experienced by Malaysia, Asia’s largest oil exporter.  For the first time in five years, the Malaysia stock market showed poor performance on the back of the low oil prices.

 

One of the main worries of the prevailing low crude prices is its potential to adversely affect the environment.  There have been significant efforts globally to address the climate change and related environmental degradation by shifting the appetite of a fossil-hungry world to clean technology, smart climate technologies, and renewable energy sources.  But clean technology is expensive.  At very low crude prices, innovative clean technology and related renewable energy sources become less attractive.  So one of the downsides and the cost of low crude prices is worsening environmental conditions.

 

The markets for innovative clean energy solutions have stagnated because of high initial cost to consumers, besides needed adjustments in energy-consuming behavior.  So lower crude prices bring high environmental associated cost to the world unless there are conscious efforts and commitment to support investments in the clean technology sector.  The environmental cost is indeed too high a price to pay for cheaper crude oil.

 

On a brighter note, the previous three oil price plunges in the last thirty years, have triggered global economic growth and prosperity.  Going by these, the current low prices should bring significant relief to most oil importing countries and industries.  The profitability of airlines, for example, returned to positive territory on the back of the more than 50% drop in crude prices in the past six months.  Lower prices at the pumps means consumers will have higher disposable incomes, which will generate additional demand to strengthen and drive economic growth.

 

The low prices should be a catalyst for resurgence of the world economy as has happened in the previous three cycles.  Looking into the horizon, industries and companies have a twelve-month window of low crude price regime from which to consolidate their energy cost structure and strategize through long-term commitments.  The reason, “The prevailing low oil prices are not going away now, at least for the next twelve months”.

 

The OPEC members have placed a high priority on the protection of their market share over prices and income.  They are not ready to entertain a new competitor, the U.S., becoming a major oil supplier.  Saudi Arabia remains resolute in maintaining current production levels even if prices fall to US$20 per barrel.  Thus, when market share drives the agenda, oil prices are likely to stabilize at low levels, a situation the market is currently experiencing.  This also affirms that high prices, per se, do not always dominate the strategic choices of oil-producers.

 

As a caution to an emerging economy like Ghana, the age-old lessons from economies built on commodities and the extraction sectors have once again been re-echoed.  The country should not continually refuse to learn that “Commodities cannot guarantee a sustainable resource mix to support a fast economic growth and development agenda”.

Bennet Kpentey is a management and financial consultant who has worked extensively in the oil and gas and energy sectors. He can be contacted at: bennetkpentey@yahoo.co.uk