Confusion abounds – just why are lower energy costs “bad”?
Confusion abounds – why are lower energy costs “bad’?
On Friday 5 Dec, the Dow was less than 9 points from 18,000. The S&P and the Dow had just set new all-time closing highs. Then, this past week, both the Dow and S&P had their worst single week performances in a couple years as energy shares dragged them lower. The 10 year US Treasury note, due to foreign funds flooding in looking for any yield, along with those from high-yield oil bond holders getting skittish and looking for safety, dropped to two year low of 2.09%. (The 10 year German note, known as the bund, is yielding only 0.623%, by comparison…)
And…US crude closed at its lowest point since May, 2009.
One obvious reason for the market drop is that the energy sector shares continue to move lower with those Brent and US crude prices. In addition to that, we have the usual portfolio adjusting at year-end and tax-loss selling adding to pressure. However, a big reason given for the selling is that the lower energy prices will, somehow, cause headwinds for the global recovery. The attendant uncertainty is also something the market doesn’t do well with.
How did lower costs for the commodity that, more than others in my opinion affects the global economy become a bad thing? For sure, it’s been tough on our exploration and production companies, those who actually punch the holes and take the major risks, as well as energy exporting countries. For almost everyone else, the new world of market-driven oil prices seems to me to be a net positive. Let me try to put the current oil price in a better long-term perspective.
Look at some facts
What we’re seeing now reminds me of 1985 – 1986 when oil prices dropped significantly with the resultant negative effects on oil-producing areas here and abroad. As was the case then, the falling energy prices hurt major oil exporters that rely heavily on petroleum revenues. OPEC, especially those other than the Saudis and Iran, is at the head of that list.
According to the Financial Times, “(OPEC members) The Republic of Congo, Equatorial Guinea, and Angola – three West African nations that rely on oil to fund the lion’s share of their economy and state revenues – will likely be hit the hardest. The near-$40 a barrel fall in crude prices since June represents billions of dollars in lost revenue equivalent to roughly 20% of their gross domestic product.” The Russians and Venezuelans also rely on oil for the majority of their revenues.
Over the past 10 years, due to political issues, supply interruptions and global demand growth, we’ve been paying premiums for energy. High oil prices stimulated drilling and more production, but squeezed consumers. Low prices, less drilling and production will free up resources for consumers to spend on other things.
According to a recent Wall Street Journal (WSJ) article, from 1985 to 2005, “crude oil prices largely ranged between $20 and $40 a barrel in today’s money. The average inflation-adjusted price of West Texas Intermediate oil since 1970 is a little under $55 a barrel” – which is very close to what it is now. The only real mystery is why it took so long for oil prices to finally drop. OPEC is drowning under a gusher of tech-driven oil production.
“Normal” oil demand grows by about 1%–1.5% a year. Meeting this demand growth for about 0.9 million to 1.2 million barrels per day (bbl/d) isn’t easy. Oil needs intense investment just to keep production flat, because producing fields decline by about 6% a year. So the world needs new projects to deliver about 6.5–7 million bbl/d of new supply…just to preserve current spare capacity. So, drilling sure isn’t stopping.
Edward Morse, global head of commodities research at Citigroup, has said that, “Each well currently being drilled in the main shale plays produces more than 550 barrels a day,” noting that it was 150 barrels on average just a few years ago. He added that, “Only five or six years ago, shale wells used to take 70, 80, 90 days to compete. Today they take two weeks and those wells run for three months before the decline starts. Costs are much lower, at $35 to $45 per barrel, in the Bakken of North Dakota and Eagle Ford in Texas.”
Oil price projections
I’ve seen way too many market cycles to guess on near-term energy price moves. However, here are some sources that are braver than I in that regard.
The chief executive of Kuwait’s national oil company said oil prices were likely to remain around $65 a barrel for the next six to seven months. Haven’t seen any revision to that, as a result of the selling…
Bank of America has warned that the OPEC oil cartel no longer exists in any meaningful sense and crude prices will lump to $50 a barrel over the coming months as market forces shake out the weakest producers.
Sabine Schels, Citibank’s energy expert, believes that, “it will take six months or so to whittle away the excess oil on the market, with US crude falling to $50, given that supply and demand are both inelastic in the short-run.” She said that will create the beginnings of the next shortage. “We expect a pretty sharp rebound to the high $80s or even $90 in the second half of next year.”
Morgan Stanley said in a report that the current price would need to fall as low as $35 or $40 a barrel to stop production and rebalance supply. Still, the bank noted that the price will likely rise eventually. “Oversupply is likely exaggerated and the market may be complacent about upside risks,” the report said.
What’s the global upside?
The benefits are huge. Here are just a couple on an international level.
For instance, and again according to the WSJ, “for major oil importers, such as Japan, Italy and Germany, the International Monetary Fund calculates that the price plunge since June could add nearly a percentage point of gross domestic product to their economies.” IMF Managing Director Christine Lagarde has said, “There will be winners and losers, but on a net-net basis, it’s good news for the global economy.” (Italics mine.)
Here’s an example of what she means. For Djibouti, Seychelles and Kyrgyzstan, whose net oil imports take a huge chunk out of their economies, the decline in prices is a bonus worth up to 11% of their GDP. This then allows their consumers to spend on goods and services that can fuel economic growth.
Bank of America seemed to support her view as it said the oil price crash is worth $1 trillion of stimulus for the global economy, equal to a $730bn “tax cut” in 2015.
How about in the US?
With the national average price of regular gasoline having fallen almost a dollar a gallon since April, falling energy prices have been a real boost for consumers and businesses. One estimate calculates that US businesses and consumers would have spent an additional $280 billion if prices had held at their June 2014 peak.1 The result should be more money available to be spent on other goods and services.
As recently as 2008, 66% of our crude oil was imported. In 2014, through September, 61% of crude came from domestic production.2 Consequently, the majority of money spent in 2008 on petroleum-based energy flowed out of the U.S. economy, while today the majority of our energy dollars stays at home.
With our energy supply more dependable than it has been in decades and the cost likely to stay in a reasonable price range for some time, manufacturers can plan production, workers can plan commutes, power companies can plan capacity and shippers can plan capacity.
As I said in another recent market letter, the cure for low prices is low prices. As global growth picks up and inventories get worked down, we will see energy and related prices rise, again as happened in the mid-80s. I believe our energy revival is definitely here to stay…and even expand as we better connect new supply with existing demand.
In my opinion, what is most important about the current and developing energy situation isn’t the particular price – there are winners and losers at any price. I think it’s the dependability of our supply. Reduced uncertainty supports risk taking, and risk taking promotes growth all across the economy.
And that is definitely a good thing!
- Capital Economics, “United States Economics Update,” December 2, 2014.
- US Energy Information
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