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02

Impacts of falling oil prices

Open-access content Thursday 29th January 2015

With the price of oil down, Gail Tverberg asks how the commodity is likely to perform in the next few years and predicts the many likely effects on the energy market and the global economy

2

Why is the price of oil dropping so much, when we seem to be reaching the substance's extraction limits? Is the price fall a sign that this stage is, in fact, still far away? Or is it very close at hand, but approaching surreptitiously?

Many people believe that these limits will appear as oil shortages and high prices. But perhaps low prices could also be a sign that we are nearing the end of viable extraction.

The issue could also be one of affordability. In a networked economy, what we can afford to pay for oil is as important as the cost of extraction. And this is influenced both by income levels and debt levels. If we look at the data, there is no big surge of oil production in the second half of 2014 to explain the huge drop in price. Instead, there are several issues that have been adversely affecting the affordability of oil.

  • Wages around the world have been stagnating, while the cost of oil extraction has continued to rise at about 10% per year.
  • The US programme of quantitative easing (QE) was discontinued in October 2014, after a period of tapering.
  • Until recently, China was on a programme of rapid infrastructure building and growth in debt to support this. Since May 2014, this has slowed substantially, and house prices there have been dropping. 

In fact, if we look at the beginning and end points for US QE, we can see a startling relationship. QE has the effect of lowering interest rates, especially on long-term debt. 

It appears as if this is was what was needed to pump oil prices back up in late 2008. 

The removal of US QE in late 2014 had the opposite effect: it let prices drop back down. This effect was made more pronounced by stagnating wages around the world and China's recent slowdown in debt growth. If I am correct about the nature of the drop in oil prices, we can expect to see a range of consequences during the next couple of years.

World oil supply price

 

Increased debt defaults - particularly on debt associated with oil extraction from US shale formations and on US dollar denominated debt loaned to emerging markets. Loan defaults in China may become a problem as well, discouraging future investment there. European countries with debt problems, such as Greece, may reach crisis points.

Rising interest rates - starting first with subprime energy loans and emerging market loans. The US Federal Reserve may add to the problem by raising target interest rates as well. One reason this might be done is to stop the rise in the US dollar relative to other currencies. If the rise is not stopped, dollar-denominated loans from other countries will become increasingly difficult to repay.

Increased recession. Increasing interest rates make the purchase of factories and goods such as homes and cars less affordable. At first, this effect may be offset by the impact of lower oil prices. Eventually, though, supply chains will be broken because interest rates will be so high that subprime borrowers and emerging market countries will not be able to afford to compete. 

Rising unemployment - because of cutbacks in oil production and increased recession. Some oil companies, including North Sea companies and US shale companies, may stop production altogether, adding to this problem.

Decreased oil supply - starting perhaps in late 2015. The timing is not certain because businesses are likely to continue extraction where wells are already in operation, since most costs have already been paid. Also, some firms have purchased price protection in the derivatives market. 

Disruptions in oil exporting countries - such as Venezuela, Russia and Nigeria - may occur, because of low oil-related tax revenue as oil prices remain low. Some countries may experience overthrows of existing governments and a sharp drop in oil exports. Some central governments may disband, as happened with the Soviet Union in 1991.

Inability to restart the oil supply - even if prices should temporarily rise. The production of oil from US shale formations has been enabled by very low interest rates. 

If there is a major round of debt defaults by the shale industry, interest rates are unlikely to fall back to previously low levels. Thus the new price will need to be higher than the $100 per barrel world price that enabled production recently. There will also be a lag in restarting production, meaning that high prices will need to be maintained for some time. This seems impossible without crashing the economies of oil importers.

Defaults on derivatives - because of sharp and long-lasting changes in oil prices, interest rates and currency relativities. Securitised debt may also be at risk of default. 

Continued low oil prices - except for brief spikes, because of high interest rates, recession, and low 'demand' (really affordability) for oil.

Drop in stock market prices - reflecting the poor condition of the economy, as well as the impact of rising interest rates.

Drop in market value of bonds - resulting in lower prices on bonds in current portfolios. Bonds are also likely to experience higher default rates.

Changes in international associations - such as the European Union and the International Monetary Fund, as it becomes clear that they are unable to deal with the problems at hand.

In total, we are eventually likely to experience a much worse situation than we did in the 2007-9 period, although this may not be evident at first. It will only be after some of the initial 'dominoes' fall that we will see what is really happening. Initially, the economies of oil-importing countries may appear to be doing fairly well, thanks to low prices. 

Other problems, that may not be evident from the previous list, include the following.

A spillover of bank problems

If banks have large losses on derivatives and securitised debt, governments have indicated they no longer want to cover such risks. Because of this, losses may be passed on to depositors through 'bail-ins' that 'haircut' bank deposits. 

Some businesses (including insurance companies) may find that funds intended for the employee payroll or claim payments are gone, because they were taken through a bail-in to assist a failing bank.

One proposal is to protect banks with an additional layer of capital, in the form of debt that can be converted to stock if the bank gets into financial difficulty. These bonds, commonly referred to as cocos, would need to be sold to insurance companies and pension funds in order to generate a sufficiently large funding amount (about $1.2 trillion). 

Long-term economic contraction

If we are really hitting affordability limits for oil, the situation cannot be expected to get better over time. Oil production is likely to start dropping and may never increase again. 

Insurance companies, pension plans and banks all build their models on the assumption that the world economy will grow forever. If we are really hitting oil limits and these are leading to slow or negative growth, this will be a huge problem for financial institutions of all types. We can no longer expect stock prices to grow for the long term, and bonds are likely to have permanently high default rates. Banks may also fail because of this.

Climate change

In recent years, the major environmental concern has been climate change and the changes needed to prevent it. While this is an important issue, it is not the only issue. It is very easy to build models showing large increases in temperature over the long term by assuming fossil fuel use and the economy will both grow forever. If this assumption is wrong, then climate models need to be 'toned down' to match a more realistic growth scenario.

A risk that would seem to be at least equally as great is the possibility that the global financial system will stop functioning at some point, instead of growth continuing indefinitely. Resources that we get from the ground are subject to diminishing returns. They don't run out; they become more expensive to extract. 

At some point, the cost of extraction of many commodities rises to a level that is higher than people can afford and the price falls below the cost of extraction. That seems to be where we are now. Actuaries would seem to have as many talents as anyone in fixing the financial system to prepare for this eventuality.

Gail Tverberg FCAS is a writer and speaker on energy issues and author of OurFiniteWorld.com

 

This article appeared in our February 2015 issue of The Actuary.
Click here to view this issue
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