Morningstar Magazine - February/March 2015 - 20

Dispatches

Surging Oil, Tanking
Prices Although oil
prices will rebound, a
permanent return to
$100 a barrel is unlikely.
ECONOMIC OUTLOOK

Francisco Torralba

From February 2011 until June 2014, a barrel
of Brent traded below $90 on exactly three days.
This past July, only two of 49 forecasters
polled by The Wall Street Journal expected oil
to fall below $90 by the end of the year.
An ever-growing population, plus ever-shrinking
oil reserves, meant that $50 oil was mere
nostalgia, like $1 movie tickets. Or so we thought.
In the last trimester of 2014, the price sank to $55.
Where did that come from? Is this a temporary
or a permanent fall? What are the consequences?
Congratulations, You're a Winner!
(Restrictions Apply)

If you're reading this, I bet you benefit from
cheaper oil. In the short term, lower prices benefit
oil-importing countries, a category that
happens to include the five largest economies in
the world: United States, European Union,
China, Japan, and India. Altogether, they account
for two thirds of the world's gross domestic
product (in nominal terms, at market exchange
rates), and half the population.
A $10 fall in the price of oil transfers $325 billion
a year from oil producers to consumers. If the
average price in 2015 were $70, $30 lower than in
2014, the gift would amount to 1.2%
of world GDP.
When oil prices change, one minus one doesn't
equal zero. The winners are, largely, households in
rich countries. They are many and spendthrift.
The losers are few: the governments of oily
countries and producing companies. They're both
also less constrained by current income than

Morningstar February/March 2015

consumers, so it'll be a while before they cut
investment, dividends, etc. Overall, then, cheaper
oil lifts global spending-for now.
The crude rule of thumb is that U.S. demand
increases 0.1% for every $10 drop in the price of
oil. European consumers hurting from high
unemployment get a much-needed lift. But there's
a catch. Consumer prices track the cost of
black gold in the short term. Persistently low oil
prices could mean that U.S. inflation will
fall below zero. The eurozone in December was
already in technical deflation.
The D-word gives central banks the jitters. If
consumers expect prices will keep falling,
they will put off spending. If nominal incomes fall,
debtors will have a harder time paying back
their loans. Expectations of deflation will cement,
making it hard to break the destructive loop.
Real interest rates will rise, sucking the
life out of asset prices and investment. And having
hit the zero lower bound, conventional monetary policy is impotent. While I think the fabled
debt-deflation spiral is unlikely (even Japan's
experience was more like a malaise than
deadly spiral), our central bankers don't want to
take the chance.
For oil exporters, the effects of cheaper oil are (no
surprise) negative. Income, profits, and fiscal
revenue will all go down, but to different degrees,
depending on how hooked the economy is on
oil. For example, energy makes up 70% of Russia's
exports, 25% of its output, and 50% of government
revenue. Cheap oil, consequently, is wreaking
havoc there. By contrast, Norway's net exports of
oil and gas amount to just 10% of GDP, and 29%
of the government's receipts. Its massive sovereign
wealth fund (almost $1 trillion) should help
soften the blow.
According to data from the International
Monetary Fund and the Financial Times, most
major producers outside North America
run a fiscal deficit if the price goes below $100
(see chart). Cheaper oil will mean less
revenue, tighter budgets, and currency depreciation-wherever the exchange rate is not
fixed. And if inflation expectations are not wellanchored, higher inflation is likely.

Supply, Supply, Supply

Why are prices falling? The most important reason
is plentiful supply.
As oil prices increased in the mid-2000s, energy
companies found it profitable to extract oil
from shale formations. Crude production in the
United States alone jumped from about 5
million barrels per day in 2008 to 9 million now,
out of a worldwide total of 75 million. The United
States is on track to overtake Saudi Arabia
as the world's top producer. Including ethanol
and other liquid fuels, the United States is already
number one. Crude production in Canada has
increased by about 700,000 barrels per day since
2008, thanks to tar sands.
Until recently, the extra oil from North America had
a muted effect. The boom coincided with
disruptions in the supply from Libya, Iraq, and Iran.
That took about 3 million barrels of daily
production off the market. But in 2014, things
changed. Libya's output, for instance, according to
OPEC's Monthly Oil Market Report, increased
by 400,000 barrels per day since the summer. That
led to OPEC's total production rising to 30.3
million barrels per day in the third quarter of 2014
from 29.8 million in the first quarter.
In November, as excess oil kept piling up, Saudi
Arabia announced it wouldn't scale back
production. As the only major producer with spare
capacity, it can steer world prices, while everybody
else acts as a price-taker.
The Saudis might be trying to defend their market
share. A recent interview with the Saudi oil
minister supports this view: "It is not in the
interest of OPEC producers to cut their production,
whatever the price is," said Ali al-Naimi in a
recent interview with Middle East Economic Survey.
"Whether it goes down to $20, $40, $50, $60,
it is irrelevant." He added that we may never see a
$100 price again. For now, he's certainly
crushing it.
Wall Street estimates that most shale projects in
the United States turn a profit at $60 a barrel.
That means many wells are losing money as I write
this column. Companies should look hard at
where they pump and put off production in the

Morningstar Magazine - February/March 2015

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