What Goes Up Comes Down and What Goes Down, Comes Up

Oil prices are cyclical. They don’t stay up forever or stay down forever. Investments are made on price expectations over the life of a production project. Most if not all of the investors in shale oil factored this reality into their investment analysis.

OPEC’s decision was based on a number of factors, mostly involving politics. Producing countries are notorious for cheating on their quotas. Holding to the agreed upon production level was a message to cheaters that they needed to reign in their over production instead of looking to Saudi Arabia to make the cuts. Saudi Arabia also is reasserting its dominance in the Gulf and explicitly attempting to weaken Iran’s influence. One of the benefits to the US and EU is the crushing effect on the Russian economy which relies on oil and gas exports for the majority of its foreign exchange.

Clearly, OPEC, and especially Saudi Arabia would like to slow US-Canadian shale and oil sands investments and production to reverse the decline in prices and re-establish its dominant role. North American oil production provides the world’s surplus and price cushion.

It is not clear how much lower prices have to fall to reach a new equilibrium, which is not immediate. As Daniel Yergin pointed out in Monday’s Wall Street Journal, “… U.S. production is more resilient than anticipated. There has been a widespread view that at around $85 or $90 a barrel extracting “tight” oil from shale would no longer be economical. However, a new IHS analysis based on individual well data finds that 80% of new tight-oil production in 2015 would be economic between $50 and $69 a barrel. And companies will continue to improve technology and drive down cost”s.

Clearly, companies will re-evaluate their near term investment decisions to reflect the drop in revenue from today’s lower prices. Those decisions will impact new investment and not production from existing fields as long as the price per barrel is at least equal to the cost of producing more barrels. For 2015, at least, US production will continue at current levels or higher.

Lower prices are like a tax cut that put more money in the pockets of consumers. We have seen consumer confidence increase in recent months and that will lead to increased spending which is good for the economy. Lower prices also affect the price of consumer goods, which helps to keep their prices in check.

Lower prices also lead to increases in demand as driving increases, larger vehicles sales increase, and travel increases.

The drop in oil prices has been caused by economic weakness in the European economies and the economies of China and other emerging nations. As lower prices lead to increases in spending and demand, the price cycle will reverse and prices will start to increase. Whether a new equilibrium price is in the $70-$90 dollar range is food for economic punditry. Absent some “black swan” event it is unlikely anytime soon to return to recent prices well above $100.

The worse outcome to today’s falling prices would be for the government to feel compelled to “do something.” Energy history since 1974 has unambiguously demonstrated that government involvement in energy markets causes harm and does no good. Further, there is no chance that the federal government would do anything that would be seen as helping oil companies achieve higher prices and transferring money away from consumers.

Markets work. Left to their own, they correct in both directions. Economic growth around the globe is the most effective way to stop oil prices from falling, which would be a sign of economic health.

 

This article appeared on the National Journal’s Energy Insiders weblog at https://disqus.com/by/wokeefe/

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