Low oil price carries economic counterweights

Oil prices are down from June highs above US$115 a barrel. Bernadett Szabo / Reuters

Judging by some lurid early October headlines, Opec’s oil producers are at each other’s throats amid a panic over plunging oil prices.

There may well be fractiousness among its members, but the stories presuppose that Opec has been anything other than a loose talking shop for many years now. The fact is oil prices have been primarily driven by economic growth, and the 20 per cent decline in benchmark oil prices since their summer peak came as data consistently pointed to weaker economies, particularly China.

Oil prices are down from June highs above US$115 a barrel, although still above $90 a barrel in early October; that is, within the perceived target range of the Arabian Gulf swing producers, primarily Saudi Arabia, which has persisted for more than four years.

Furthermore, the decline has been in line with a broader fall in commodities prices, underpinning the argument that it is primarily an issue of weak economic growth. As Capital Economics, an independent analysis firm, noted about the weaker commodities prices: “The underlying picture is far more nuanced than the headlines might suggest and it is actually encouraging, on balance, for global economic prospects.”

For one thing, Capital Economics argues, a strong dollar has tended to exaggerate the decline of commodities prices; some commodities are still experiencing good underlying demand. Also “cheaper energy will itself help to support global growth”, the report points out.

Falling oil prices tend to also self-correct on the supply side, leading to postponement of the more expensive oil extraction projects such as hydraulic fracturing and oil sands. For example, a report last week in Canada's Globe and Mail noted that "for the Alberta energy industry, weaker prices mean oil sands companies can no longer count on constantly rising prices to cover ever-increasing costs of massive megaprojects".

In the near term, however, there is little encouragement from the global economy. The IMF’s managing director, Christine Lagarde, said last week that the IMF was likely to pare back its growth forecast when it meets this week in Washington. Its last forecast in July was for 3.4 per cent growth this year for the global economy, rising to 4 per cent next year.

Amid the economic gloom, the tone of panic in the oil market has been partly because of signs that the Saudis and others have begun to defend Asian market share with lower prices. The Saudis cut their official selling prices to Asia by the largest amount since 2010 as tanker loads of crude from as far afield as the North Sea and Alaska were spotted heading to Asian destinations. The Kuwaitis followed suit.

The question now is what happens next year when additional supply, especially from North America, is due on the market.

“Looking forward, there appears to be a higher probability of downside than upside price risk,” said Ed Morse, the head of energy analysis at Citibank. “The Opec Secretariat itself is indicating that the call on Opec for 2015 is a good 1.5 million barrels per day lower than current group output. In this context, Saudi Arabia and other [GCC] countries show no willingness to cut production and Saudi officials indicate that the market supply balancer might be US shale if prices fall too low.”

In other words, the best bet for the market might be that lower prices discourage higher-cost producers, thus keeping extra supply – a million barrels from the US alone next year – off an already glutted market.

An unexpected boost to economic growth would be less painful for all concerned.

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