Over the Barrel: Oilpolitik

This column first appeared in the Indian Express, on January 5, 2015. Like other products of the Brookings Institution India Center, this is intended to contribute to discussion and stimulate debate on important issues. The views are those of the author.

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 8-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% of US shale production will be uneconomic at prices below $80 per bbl. Wood Mackenzie has written that 60% 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-50s. 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 approx $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.