A frequently asked but futile question
is: Where are oil prices headed? The
question is futile because no one
knows the answer.
This does not mean that people do
not analyse and speculate. It is just
that they get it wrong more often
than not. The more useful questions
would be: What are the implications
of the recent downturn in oil prices?
What, if any, are the opportunities
that this decline offers?
The price of crude oil was $115 per
barrel (bbl) in June last year. Today it
has fallen to below $60 per bbl.This
decline was unanticipated. Prices
have fallen comparably sharply in the
past, but there has been an
explanatory external trigger each
time. Between 1997 and 1999, prices
fell from $25 per bbl to $10 per bbl.
The trigger was the Thai
government’s decision on June 30,
1997, to stop defending its currency.
This snowballed into the full-blown
Asian financial crisis. Between July
and December 2008, prices went from
$145 per bbl to $35 per bbl. Here, the
triggers were two-fold. First, prices
had run up to an unsustainable level
and second, investment bank Lehman
Brothers went belly up in September
and banks stopped lending. This time,
however, there has been no external
trigger. Prices have slid because
supplies have outrun demand.
The International Energy Agency (IEA)
had projected that oil demand would
rise by 1.4 million barrels a day in
2014 over 2013. But demand
increased by only half that amount —
7,00,000 barrels a day. On the supply
side, the US tight oil producers
(shale) exceeded production
expectations by 1 million barrels per
day (mbd), and Iraq and Libya by 200
and 300 thousand barrels per day,
respectively. In addition, Opec passed
the baton of “swing producer” of oil
to the US. Instead of cutting
production to defend prices, it
decided to defend market share. To
close observers of the petroleum
market, this shift in policy should not
have come as a surprise.
For, in September 2013, Saudi
Arabia’s minister of petroleum had
said that US shale oil production
should become the “world’s new
swing producer of oil”. Later and all
through 2014, both he and the Opec
secretary general repeatedly made
clear that Opec would not play its
traditional role; that with its lower
cost reserve base it had the staying
power to withstand any price
pressure; and that US shale
producers should hold back
production if they did not wish to be
driven into an economic hole.
They knew that US producers could
not “cartelise” and buck competitive
forces, so these statements were
deliberate signals to alert the market
of their altered attitudinal stance. So
when, at the Opec summit meeting in
November, they rolled over the
output quotas of individual members
unchanged, the price of crude
slithered sharply.
Opec is gambling that it will not be
long before US production stagnates
and that, with faster growth in the
US, China and India, the current price
trend will reverse. This is a gamble,
because there is an eight-month lag
before drilling activity responds to
price signals. Also, the price point at
which the marginal costs of shale
production exceed marginal revenues
is not clear.
The IEA has estimated that 4 per cent
of US shale production will be
uneconomic at prices below $80 per
bbl. Wood Mackenzie has written that
60 per cent of production from new
wells are commercial at $60 per bbl.
Cambridge Energy Research
Associates has calculated the average
break-even cost to be in the
mid-2050s. This variance is
understandable. It reflects the
different cost profiles of the
companies. Those that came into the
game early and leased land at
knockdown prices and have
established the required drilling
infrastructure can probably make
money at prices below even $50 per
bbl. Others must already be
struggling.
The important point is that while the
shale business model is clearly under
stress, oil producers are also hurting.
The Russian currency is in near
freefall; Venezuela is finding it
difficult to service its debt; Iran
needs $135 per bbl for fiscal break-
even. Saudi Arabia, the UAE and
Kuwait have seen their revenues
decline by approximately $240 billion.
The Brazilian pre-salt fields are fast
becoming uneconomic. The Opec
position is a gamble because if prices
stay at this level for long, or slide
even further, most of these countries
will face an economic, if not political,
convulsion.
The implications for India are, of
course, on balance hugely positive. It
has saved approximately $40 billion
in reduced import costs; inflationary
pressures have eased; the subsidy
outgo has reduced and growth has
got a boost. But there is a flipside.
Indian companies have substantive
investment, trading and financial
interests in Venezuela, Russia,
Nigeria and the Gulf. Were Venezuela
to renege on its debt, Russia to sink
deeper into recession, Nigeria to
impose capital controls, Iran to suffer
a political upheaval and the Gulf
countries to cut back on public
expenditure, the returns on these
investments would be at risk,
remittances from Indian workers
would slow down, and our strategic
and trading relationships may have to
be reviewed.
At the sectoral level, it will be
increasingly difficult to attract risk
capital into oil and gas exploration.
This is because most oil companies
have pared down their exploration
budgets. The government is
reportedly planning to announce a
new licensing round for bidding. If
so, and if it is keen to attract
international companies, it will have
to abandon all thoughts of replacing
the current cost-recovery production-
sharing model (where companies
have first call on production to
recover costs) with a revenue-sharing
model (where revenues are shared
with the government even before
costs have been recovered).
The oil price decline raises two
questions. First, does it offer
acquisition opportunities? After all,
many international companies with
attractive assets are hugely leveraged
and face a cash crunch. They may well
need to sell at significant discounts.
Indian companies with deep pockets
and/ or sovereign backing should
perhaps investigate.
Second, at what point and under
what circumstances will prices start
to climb again? That they will is a
lesson from history. In anticipation,
the government should develop
scenarios that describe alternative
futures under different, albeit higher,
price points and be ready with its
policy response.
The writer is executive director,
Brookings India and senior fellow,
Brookings Institution
