Falling crude oil price: Will it stay for long?

The price of crude oil has come down from $110 to $85 a barrel within a few weeks, despite the fear that the troubles in Middle East (specially the rise of IS and trouble in Libya) would cause a spike in oil price.

This has helped reduce the inflation rate, squeeze the trade deficit and contain the oil subsidy bill.

The government has taken advantage of this unexpected windfall to deregulate the price of diesel – a long-standing item in the economic reforms agenda.

The recently announced reduction in the diesel price by more than Rs. 3 a litre at one go has sent a welcome signal to consumers and politicians that deregulation does not necessarily mean a rise in price.

But the question is: Is this bonanza going to last?

Though some analysts believe that this is a mere blip, the majority opinion is that there are some fundamental forces at work which should keep the price of oil low in the foreseeable future.

The continuing slow down of Europe and Japan, and the reduced growth in the big emerging economies like China, India, Brazil and Indonesia have lowered the growth in demand for oil.

But the more important forces are operating on the supply side in the form of huge discoveries of new sources of energy – like shale oil and gas in countries like the United States and Canada – which horizontal drilling and fracking technology has made possible to extract at a cost in the $85-90 range.

Nearly all of the recent growth in global oil production is coming from the US and Canada and the former is expected to surpass Russia as the biggest producer of oil in the near future.

(By the way, contrary to popular perception, Saudi Arabia is not the biggest producer of oil, it has the highest known reserves of oil in the world).

Even renewable energy sources like solar and wind power, though initially much costlier than fossil fuel, are going through a phase of rapidly falling costs due to economies of scale and improved technologies.

Thus, the Organisation of Petroleum Exporting Countries (OPEC) cannot afford to keep price above $90 for an extended period without taking the risk of being competed out by the new energy supplies.

Can this process be reversed? Yes, to some extent if high growth returns to the major economies of the world lifting the growth in demand for energy.

Also, the supply of shale oil and gas may suffer a setback if the new – and in many cases relatively untested – technologies cause any major environmental disaster which would strengthen the ongoing protest of the environmental lobbies against these technologies.

OPEC members led by Saudi Arabia may also try to reverse the trend of falling price by cutting production of oil.

But, given that a price of oil above $90 may give a big boost to the alternative energy sources (thereby undermining OPEC’s power in the long run), it would need a corresponding huge cut in OPEC production.

Even if Saudi Arabia may afford to do it for some time, it would be very difficult to enforce that much production cut on other smaller players who desperately need oil revenue for  sustaining their economies.

Of course, any major disruption in oil supply due to war or natural calamities may cause temporary spikes around the trend price.

Gainers and losers

Who would be the big gainers and losers from this decline in oil prices? Clearly, the big oil importing nations like India, Japan and the US would gain.

However, parts of US (North Dakota, Texas), which are producing big chunks of shale gas and oil, would lose if they are not able to compete with traditional oil producers at this low price.

Russia – not a member of OPEC –  gains more than OPEC members when OPEC raises oil price by cutting supplies while Russia is under no obligation to reduce its production.

By the same logic, Russia would lose more when the world oil price drops and this would cause a big fall in government revenues in Russia (as the major producers of gas and oil in Russia are state-owned) leading to serious budgetary problems for the government – particularly when it is suffering under economic sanctions by US and EU.

The oil revenues of major oil producing nations like Saudi Arabia, Iran and Venezuela would suffer with significant implications for the global geopolitical scenario.

If the US becomes nearly self-sufficient in oil as a result of the shale gas revolution, the need for its government (and military) to be so actively engaged in the Middle East would weaken.

This would have profound significance for the balance of power in the region.

While it may reduce the chances of US-led invasions like that in Iraq or Libya to protect oil supplies, the withdrawal of US army from the area may see strengthening of forces like Al Qaeda or IS.

The conflict between Saudi rulers, Iran and Iraq may also come more in the open.

Willy-nilly, USA – as the global sheriff and protector of US oil companies – may  eventually have to intervene in the region, backing one regime against another, even if it may not be strictly needed for ensuring its national energy security.
 
I would like to end with a  word of caution while trying to predict the future.

Michael Mussa, the Chief Economist of IMF, was once asked: “What is the forecasting technique you use?” His (tongue in cheek) reply was: “Prayer.”

He explained that out of all the available techniques, prayer has not performed any worse than the others.

So, in our forecasting exercise, we, too, should  keep our fingers crossed and pray.
(The author is a former Professor of Economics, IIM, Calcutta)