More cheaper oil on the way: Why prices are tumbling

BY TAI CHISHAKWE - OCTOBER 28, 2014

Oil prices have been tumbling for most of this year - one of the steepest price drops since the 2008 financial crisis. On the international market, oil prices fell by 25 percent since mid-June, to around US$86 on 28 October.

On Monday, US investment bank, Goldman Sachs – which is known for some of its accurate oil price calls, slashed its 2015 oil price forecasts. Goldman analysts said in a report released late on Sunday that they expect US benchmark West Texas Intermediate (WTI)crude to fall to US$75 a barrel and Brent to US$85 a barrel in the first quarter of 2015, both down US$15 from previous forecasts.

WTI could fall as low as US$70 in the second quarter of 2015 and Brent as low as US$80 before returning to first-quarter levels, Goldman said.

Why are oil prices falling?

It’s odd that when the Middle East is currently unstable – with a US-led coalition battling to remove the Islamic State from Syria and Iraq, oil prices are tumbling. Traditionally, a war in the Middle East would see a spike in oil prices…

The reason is in the economics of demand and supply.

Rising production is outstripping demand, at a time when analysts are predicting consumption will be dented by slower global economic growth.

Supporting the weak demand argument is a stagnant economy in Europe, slower growth in China, and flat gasoline consumption in the US. The International Energy Agency, this year predicted that world demand for oil will grow by only 1.5 percent.

To try to keep prices high, Saudi Arabia, the world’s biggest petroleum exporter, has reduced its oil production from 10 million barrels a day—a record high—in September 2013 to 9.6 million as of September 30 this year.

However, other OPEC countries are pumping more crude as the Saudis try to slow down. Higher production from Libya and Angola, along with surprisingly steady flows out of war-torn Iraq, have pushed OPEC’s total output to almost 31 million barrels a day, its highest level this year and 352 000 barrels a day higher than September 2013.

Goldman said production outside OPEC countries was expected to accelerate, led by Brazil and drilling in the Gulf of Mexico.

Non OPEC-production outside the US is forecast to increase by 412 000 barrels per day this year, 573 000 bpd in 2015 and 505 000 bpd in 2016. Brazil is forecast to increase output by 206 000 bpd in 2014 and 325 000 bpd next year while Mexico is expected to increase by 155 000 bpd in 2015.

Combined with the continued increase in US oil production, the world has more than enough oil to satisfy current demand.

On the demand side, growth has only averaged 630 000 bpd year-on-year so far, less than half Goldman's initial forecast for 2014, the report said.

Global economic growth is forecast by Goldman analysts to increase to 3.5 percent next year but there is a "risk that the historical relationship between global GDP growth and oil demand has weakened," the report said.

Shale production

In the US, rising shale production is increasingly affecting global energy flows and eroding OPEC's pricing power, Goldman said.

Anthony Jude, a senior adviser on energy and sustainable development matters for the Asian Development Bank, cited falling US oil imports as the primary reason for lower global oil prices.

The US is "producing an additional 3 million barrels per day because of shale oil", he said on Monday on the sidelines of Singapore International Energy Week.

US crude oil imports have fallen to 7 million-7.6 million bpd from peaks above 10 million bpd in 2005 and 2006 since the advent of the shale oil and gas boom, according to data posted on the website of the US Energy Information Administration - www.eia.gov.

"US shale is the marginal swing barrel in the new order," Goldman said, adding that a slowdown in production will happen when WTI falls to US$75 per barrel.

Once prices fall and US production slows, Goldman expects cutbacks among OPEC producers including Saudi Arabia, which has been content to let prices fall in the hope of forcing US shale producers out of the market.

"Any near-term OPEC production cut will be modest until there is sufficient evidence of a slowdown in U.S. shale oil production growth," the report said.

Effect on global economy

Although that might not be good news for oil producers, it’s great for consumers and the global economy. A report by Andrew Kenningham, senior global economist at Capital Economics, attempts to gauge the difficult-to-measure global lift from lower oil prices.

“A $10 fall in the price of oil transfers the equivalent of 0.5 percent of world GDP from oil producers to oil consumers,” he writes. That in turn will have a knock-on effect on global consumption, because consumers tend to spend more of their income than businesses. Assuming consumers spend half their savings from cheaper oil, Kenningham continues, “a $10 fall in the oil price would boost global demand [for goods and services] by 0.2 to 0.3 percent.”

By lowering gasoline bills, cheaper oil prices could potentially increase purchasing power for consumers in time for the holiday sales season.

“That money is going to be moving into cash registers this fall,” says David Rosenberg, chief economist at Canadian investment firm Gluskin Sheff.

“Cheap gasoline acts like a tax cut that will flow through the U.S. economy in a big way. This couldn’t have come at a better time.”

However, in Europe, where politicians are struggling with deflation, lower oil prices will only make the European Central Bank’s challenge harder as it loosens monetary policy to try to raise consumer prices.

Abundant oil also might not be good news for some big petro states. Kenningham says Russia and most of the Middle East can weather lower prices because they socked away enough oil revenue, but countries such as Brazil, Mexico, and Venezuela will be more negatively affected “primarily because they have not been saving much of their oil windfalls.”