8 things you need to know about the oil crash

Kate Deer, Amy Gilligan and Brian Parkin answer some of the key questions surrounding the recent crash in oil prices.

Why has my petrol got much cheaper?

Anyone who drives, or has passed a filling station won’t have failed to notice that petrol prices have plummeted recently. The average price in the UK for a litre of petrol is now 109.9p, with the supermarket Asda offering it for as low as 103.7p. In the US, where taxes on petrol are lower, motorists are paying an average of $2.12 per gallon (about 37p a litre). Prices haven’t been this low for over five years.

Petrol prices are relatively low because of a crash in the price of oil. The price for a barrel of Brent Crude (the global standard) is now around to $46. Prices have more than halved from a high of $115 in June. The price of a barrel of oil hasn’t been this low since just after the 2008 crash.

Unfortunately public transport users haven’t seen the benefits of lower fuel prices – rail travellers saw prices rise by an average 2.2% at the start of the year.

So why have oil prices dropped so much?

A downwards trend in oil prices began early last year as oil stockpiled from the start of the recession, much of it afloat on tankers, was released by brokers at lower prices onto a relatively inactive world economy. Production from fracking in the US and recent deep water developments in the Gulf of Mexico has also increased, as part of desire by the US to break away from being dependent on importing oil.

A sudden over-supply into a global economy, only tentatively exiting recession, followed by Japan going into depression, the return of the EU into recession and the slowdown of China initially created a surplus-led price collapse.

The geo-political element is also important. In 2008 the US was the third largest oil producer in the world, after Saudi Arabia and Russia, but by 2014 it was the largest oil producer in the world. Although the US, as the world’s largest consumer of oil, still imports large quantities of oil, this has more than halved in recent years.

Saudi Arabia isn’t very happy about this. Rather than cutting production, which would likely see prices increase, Saudi Arabia and OPEC more generally, have continued producing, meaning that prices have continued to drop. Low prices are bad news if you’re trying to make a profit from expensive forms of extraction such as fracking, shale gas or deep water rigs. By keeping prices low, Saudi Arabia are trying to curb US production and maintain their market share.

The volatility of the oil price has been further aggravated because of commodity trading. This means the oil price can drop simplicity because commodity traders speculate on it by going short. For example, when Goldman Sachs published a report arguing that the oil price will fall down to $42 per barrel, it drove the oil price below $50. Their forecast became a self-fulfilling prophecy.

But don’t lots of countries economies depend on oil?

Not surprisingly, a drop in oil prices is bad for oil exporting countries. The extent of the damage depends a lot on the general economic position of the particular country.

The top oil producers are the US, Russia and Saudi Arabia. Between these countries, there are big differences. In Russia, energy accounts for 70% of all exports, and 50% of budget revenues. This makes a drop in oil prices very painful. Similarly, 90% of Saudi Arabia’s export earnings and 75% of its budget revenues are derived from its oil industry.

Although the US is becoming an increasingly important producer of oil, it has banned exports of crude oil for more than 40 years. The entire oil industry is aimed for domestic consumption, which means its national economy will be relatively less affected by the crash in prices.

Another factor is the overall wealth of a country. A fall in income is obviously easier to cope with for countries that have a high overall level of GDP and wealthy citizens such as Saudia Arabia, compared to a poor country such as Equatorial Guinea or Gabon. In these countries a fall in oil prices will have much more severe impact.

The situation can be imaged as a big arm wrestling game between OPEC, Russia and the US. Each party wants to control its share of the market, which is why they refuse to cut down their production. Unfortunately, many smaller parties get crushed in the middle. These are the countries such as Venezuela or Angola that are both, heavily dependent on oil exports and relatively poor. Iraq has now reached the highest level of oil production in 35 years, yet revenues from oil production have reached a 5 year low. Similarly, South Sudan’s oil revenues have dropped by 80%, according to the Middle East Economic Survey.

Another downside for the oil exporters is the impact of a price drop on their currency. While a country is losing money, those who hold the currency might lose faith in its value. This is what happened with the Russian rouble. As of December 2014, the rouble had lost more than 50% of its value against the dollar. Similarly, Nigeria has had to devalue its currency, the Naira by nearly 10% as a result of the price drop.

Can you explain a bit more how fracking fits in with all this?

The expansion of fracking, the extraction of oil and gas by pumping high pressure fluids into rock to fracture it, is a crucial element in understanding the crash in oil prices. Fracking has been in use for over 40 years as a way of squeezing more oil out of conventional wells. Today fracking has grown as a way of extracting oil in its own right.

New fracking developments are the reason the US is now the number one oil producer in the world. Production in the US has increased to around 11 million barrels per day. In North Dakota, for example, a state with extensive fracking developments, production has increased from 200,000 barrels of oil a day in 2007 to more than one million barrels a day.

Curbing the growth in US production from fracking, to try and maintain their market share is one of key reasons that Saudi Arabia and OPEC more generally haven’t cut production. Fracking is a very expensive form of oil extraction: the median cost per barrel is $65. Pushing oil prices down for a significant length of time could force producers who rely on fracking to go under.

While for 2015 US fracking producers have insured heavily against price falls below $90 per barrel, prices are now below $50 meaning they are potentially fatally exposed. It is estimated that at the current oil prices 90% of fracking companies are unprofitable. Further, many of the fracking develpments have been financed through borrowing money, leading to worries that many fracking operations could default on their loans, leading to a similar situation to the sub-prime mortgage crisis which lead to the 2008 crash.

How’s the oil industry coping with the oil price crash?

The effect of the oil price crash are taking some time for the full impact to be felt, however within the oil industry itself there has already been some activity

At the end of December oil and gas industry contractors Schlumberger sold off around half of its North Sea survey vessels, and large job losses are expected among their engineering and survey staff. Petroleum giants Shell and BP have once more entered into merger talks as a way of risk sharing on current and future developments. This merger would result in a company equal in size to Exxon/Mobil and would inevitably mean massive job losses.

Oil companies operating in the North Sea have already announced cuts to pay and jobs. Many of those employed are contractors and so news of job losses may not be widely reported, however Conoco Phillips have announced 230 job losses out if its 1650 UK workforce and Premier Oil have said there will be massive ob losses over the coming year. Wood Group have announced a pay freeze for all their staff and the immediate dismissal of all contractors and both BP and Shell have cut contractor pay by 15%.

In the United States, 756 workers in Ohio and Texas have been sacked by US Steel, a company that makes steel pipe and tube for oil and gas exploration and drilling.

And what about impacts on the economy more generally?

At first glance there seems to be both up and downsides of the low oil prices. Low prices are bad for exporters, but oil importers such as China and India are benefiting. The drop in oil prices is good news for consumers: not only do they have to pay less for travel, it could also reduce costs of manufacturing, and in turn prices of consumer goods. The IMF even predicts that global GDP will gain between 0.3 and 0.7% as a result of low oil prices. However, these economic growth forecasts tend to be very unreliable.

There are a number of underlying challenges as a result of the lower oil price that have the potential to turn into bigger issues. One is the fact that low oil prices affect currencies. As mentioned above, the currencies of oil exporters such as Russia or Nigeria have lost a lot of value recently, at the same time, currencies of oil importers, such as the US, tend to gain value.

A lower oil price aggravates the already existing pressures towards deflation in many Western economies, particularly in the Eurozone. Largely as a result of low oil prices, the Eurozone has now, for the first time since 2009, officially entered deflation. This means that the real value of the Euro has increased. This might initially sounds like a good thing as a Euro can buy more; however, it also means that the real value of debt has increased. Since the global financial crisis of 2008, the total of public and private debt has increased to 272% of GDP, this burden will be much harder to carry when the real value of debt increases.

Speaking of debt, the large-scale expansion of oil production in the US was significantly financed by debt, particularly for fracking as mentioned before. Today between 15% and 20% of all high yield bonds, that were before 2008 were called junk bonds, originate in the energy market. These junk bonds aren’t just a problem of energy companies. International investors have bought up large amounts of these, which means that pension funds and insurance companies are exposed too. According to a recent report conducted by Deutsche Bank, a sustained price level of $60 per barrel means a default rate of 30% for B and CCC rated high yield bonds. To get an idea of the size of the market, since 2010, energy producers have raised about $550 billion of new bonds and loans, out of these approximately one third is estimated to be at risk of default.

There is also potential for OPEC in the form of its present global cartel to irrecoverably fracture. Unless Saudi Arabia cuts production then other producers who are dollar-hungry may break from the cartel and try to under-cut by flooding the spot market with cheap oil just to get what they can while it lasts.

Deflation, currency crises and junk bonds could perhaps be manageable on their own. The problem is that they’ve hit the global economy in the context of already high burdens and a recovery that is largely based on speculation in the financial sector.

So how long might prices continue to fall?

Interestingly, leading economists are deeply divided on this issue. US investment bank Goldman Sachs expects oil price to remain low for the next couple of months and to even reach $42 per barrel. Another investment bank, called Investec argues that the oil price will recover throughout 2015, but it estimates that oil production in the US will be halved from 1 million to 0.5 million barrel per day.

The state of the world economy is a big factor. With Japan and the Eurozone already in recession or deflation and growth in China slowing, overall global demand might continue to fall against a background of increasing over-supply.

Prices are likely to continue to fall until national stocks are drawn down and supply discipline is restored. For the biggish OPEC members such as Nigeria and Iraq who have virtually no dollar reserves and massive internal civil crises there is a real risk of them going bust. The regional consequences of this will be huge.

And what about the climate? Do renewables stand a chance when oil prices are so low?

There are three key numbers to remember with respect to the climate and burning fossil fuels, such as oil: 2C – the internationally agreed limit on “safe” warming; 565 gigatons – the maximum amount of CO2 that produce from burning fossil fuels to stay below a 2C warming; and 2795 gigatons – the amount of carbon in proven oil and gas reserves. If we want to stay below 2C, and have a planet that we can still live on, then most of the oil and gas needs to stay in the ground.

Countries increasing their production to maintain their global dominance in the market, or even to stay afloat, are clearly doing the opposite of what we need for the climate. It is not enough for renewable energy sources to become competitive – there needs to be international agreements to stop so much oil being used.

Many of those who have lost their jobs in the oil industry recently, or could lose them in the near future are very skilled workers. Their skills will be essential in building a low carbon economy. This highlights the importance of raising the demands around a million climate jobs before people’s lives are destroyed, and the skills and potential to make the world a better place are squandered yet again.