27 January 2016

Oil boom is too much of a good thing

By Bill O'Keefe

Historically falling oil prices were a boost to the economy.  Every penny reduction in gasoline prices means a $1 billion boost to the economy.  Today, the narrative is very different.

Because the US is a mobile society, some segments are beneficiaries.  Motorists get a big break, airline profits improve, sales of SUVs and trucks are booming, and oil intensive businesses are financially better off.  Those savings in energy costs are not showing up in consumer spending.  Some may be paying down debt and others may simply be saving because of anxiety about the global economy.

There is also a big downside in the US.  Oil companies have cut back capital spending and many shale producers are facing bankruptcy because they cannot service the debt that they took on during the shale boom.  The largest oil service companies, Schlumberger, Halliburton, and Baker Hughes have announced 51,000 layoffs and it is estimated that worldwide oil job losses are on the order of 200,000.  Oil producing states are also taking a big hit because of lost tax revenue from oil companies.

In the past, a drop in oil prices produced an increase in demand, an increase in consumer spending and a slow down in production.  Eventually the increase in demand caused prices to stabilize and then increase, which led to increased exploration and production.  This time is different, very different.

While many commentators point to the slow down in the Chinese economy from 10 percent growth to 6 percent, China is only part of a more complex story. Healthy economic growth is nowhere to be found. Economies around the globe are experiencing slow growth and that is especially true in the emerging economies. EU nations are not growing and may slip into recession and US growth of 2 percent is anemic.  For the foreseeable future, economic growth will not be sufficient to reverse today’s low oil prices.

Without a large increase in demand, the only way to boost oil prices is a reduction in production, probably a significant one.  According to the Energy Information Administration (EIA), US production will decline this year from 9.4 million barrels a day to 8.7 and 8.5 in 2017.  That is necessary but not sufficient.  The needed reductions have to come from Saudi Arabia, Russia, and other OPEC nations.  The reason that a big reduction in production is needed is the historically high level of global inventories.

Although EIA does not maintain global inventory data, it does provide estimates of commercial inventories in OECD countries—developed economies.  In 2013, EIA estimates these inventories to be 2.5 billion barrels, the highest level ever recorded, which was equivalent to a 55 day supply. For this year, the estimate is 2.8 billion barrels or about a 65 day supply.  To these on land inventories, it is necessary to add storage at sea, which are estimated to be about 100 million barrels or double the level of a year ago.  The growing inventory overhang is the primary cause of falling oil prices. And, it is this historically high inventory that will keep the price low until an increase in demand is sufficient to reverse it.

The prospects for reduced production are dim.  Saudi Arabia has made clear that it will not cut production.  On the surface, that doesn’t make sense.  However, its continued production is causing shale production to decline, will significantly reduce the revenue that Iran gets when its oil goes back on the world market, and is causing a drop in hybrid and electric-vehicle sales.  Those are important strategic objectives.  The other nation that might reduce crude production is Russia, but it can’t.  Oil revenue represents over half of Russia’s budget revenue.  The combination of western sanctions, low oil prices, the flight of capital has produced a shrinking economy at a time when it needs a growing one.  A prolonged recession creates a host of problems for Vladimir Putin.

Tough economic times around the globe are going to stay tough. There are no quick fixes except some external event that causes a big drop in production.  In that eventuality, the cure could be worse than the disease.

Bill O’Keefe is president of Solutions Consulting.