Interview: Oil prices to remain low in next two years – Head of Midwest Center for Energy Law & Policy

Interview: Oil prices to remain low in next two years - Head of Midwest Center for Energy Law & PolicyOil prices continue to drop following weak economic data coming from China. On Friday, Brent crude, the global oil benchmark, fell by 0.9 percent to $46.19 a barrel on London’s ICE Futures exchange. On the New York Mercantile Exchange, WTI futures decreased by 0.8 percent to $41 a barrel.

Fenner Stewart, Director of Midwest Center for Energy Law & Policy, Assistant Professor, University of Calgary, in an exclusive interview with Trend spoke about the factors that have caused such a drop in prices and the reasons for inactivity of the oil producing countries.

Q: Oil prices continue declining slowly. Do you think they have reached the bottom, or we should wait for the next negative “record” this year?

A: Oil prices are exceedingly difficult to predict, and those who guess correctly are usually just lucky. The reason for this is that the price mechanism, which controls global oil prices, is subject to many variables beyond supply and demand.

A slightly different question is: “why are oil prices so low?” The simple answer is that there is oversupply. A more nuanced answer is that there has been a massive disruption in global production. This has been created by a number of factors: the most important being the advent of directional drilling and hydraulic fracturing. As a result, small US producers of unconventionals are more or less forced to produce, because of the massive capital expenditures that they have made and the demands for return on investment. Accordingly, the US is transforming from a net importer of oil and gas to a net exporter of gas and a reduced importer of oil.

A result of the reduction of oil prices is that oil-rich countries (which have failed to diversify their economy and rely on resource rents from high oil prices) do not have the cash to finance their government activities and must keep producing or face serious domestic problems. Venezuela has been having a tough time as of late, but so have many other countries, like Russia. So, such countries are forced to keep producing just to keep the lights on.

Then there is Saudi Arabia—the wild card. The Saudis are producing record amounts in the face of a price mechanism that is screaming: “Stop!” Why do they keep producing? The simple answer is that they do not want to lose global market share to the new US producers. But this is not a complete answer, nor does it make sense without further explanation, which the Saudis are not providing.

My favorite theory, which I believe to be the most plausible, is that the Saudis are squeezing US unconventional producers. Some of these producers are going bankrupt, while others are in need of capital infusions to keep going; either way, most of them need cash. As of the end of July, Saudi Aramco has invested over $14 billion in unconventional shale plays in the US.

The Saudis are buying working interests in US shale plays on the cheap. After they have acquired the desired percentage of these plays, they will scale back their domestic supply, and prices will rise. This will have a number of results. First, as oil prices rise, Saudi investments in US shale plays will increase dramatically in value, recouping some of the cost of selling oil cheap to suppress prices. Second, the Saudis will have secured market share, since US production will also be, in part, Saudi production. Third, income from aging Saudi reservoirs will be replaced by income from their working interests in US shale plays as the 21st Century rolls forward, ensuring oil revenues into the future.

How does Big Oil feel about this? Hard to tell, but one thing that is known is that Big Oil largely missed out on the “Shale Gale,” getting into the game late. Furthermore, Big Oil has money and if they are smart, they will follow the Saudi lead. Also, they are still making massive profits from refineries, which is surprising, but that is another story…

What about the US government? The US government’s key concern is having domestic reserves (which – all rhetoric aside – also includes the Canadian Oil Sands). Therefore they do not want to lift the export ban nor does it want Canadian crude to be shipped to “foreign” markets (think: North American pipeline politics).

Cheap oil prices help the US government to have time to adjust to the changing landscape. Also, it helps to deal with some international “problems” such as Russia, Iran, Venezuela, ISIS and others. Furthermore, if Saudi Arabia has an economic stake in US unconventional plays, then it creates an incentive structure that further tightens Saudi-US relations. This is important considering it looks like the US government is attempting to re-establish its historic alliance with Iran—which admittedly might be a tall order.

In my opinion, these are just some of the factors that have lead oil prices to be where they are, and because there are so many moving parts to the price of oil today, it is difficult to predict the future price. That said, I agree with the majority of banks that the oversupply of oil will continue and that price will remain low (possibly tipping a bit lower) over the next two years.

Q: Iran, after the lifting of sanctions can increase oil exports by 1 million barrels per day. Do you think it will have strong effect on oil prices, taking into consideration that the market is already oversupplied by 2-2.5 million barrels per day? Do you think that oil prices could fall sharply for example, to 20 dollars per barrel?

A: The lifting of Iranian sanctions could dramatically reduce the price of oil, but I don’t believe it will. The last time there was an oil glut like this was in the mid 1980s when the Saudis were fed up with other OPEC members and decided to punish them for cheating on their quotas. At that time, the Saudi opened their taps and the price fell to $7 per barrel.

This begs a slightly different question: “Do you think OPEC has the collective will to control the price of oil?” If I knew the answer to this question, I would make a lot of money.

Q: Many oil producing countries, which contribute greatly to the oil supplies, in fact, are not ready to work at low prices for such a long time. Their break even oil price is almost 2 times higher than current level. Why, in your opinion, these countries cannot reduce production through coordinated efforts to raise prices?

A: The answer to the question is two-fold. First for producers, most of the cost of drilling a conventional well is sunk, so minus initial investment, it does not cost that much to produce a barrel of oil. In other words, even if a producer is losing money on the investment as a whole, given current market prices, it is still making money over the real-time production costs. Second for most oil-rich countries, they have to maintain current production revenues to finance government activities, so they have no choice but to encourage production.

To explain the latter further, I am not a fan of the “Oil Curse Theory” for “Petroleum States.” That said, the empirical evidence clearly demonstrates that states, which enjoy “resource rent,” tend to either: (1) invest poorly when attempting to diversify their economies or (2) do not invest in economic diversification at all, remaining heavily dependent upon oil revenues to finance government activities.

As a side note, resource rent is a somewhat vague calculation of the rent (or revenue) that is surplus of the total of all costs and normal returns from the output of a resource. In other words, such countries are getting money for nothing other than being owners, thus the term “rent”. Research indicates that since oil-rich countries are not forced to diversify their economies when oil prices are high, they don’t. This leaves then with a gun to their head when prices are low, giving them no choice but to produce as much as possible.

Those countries, which are being disciplined by the market today, should be managing their economies better. It is inevitable that a shift to new carbon neutral energy resources is on the distant horizon: maybe not in 2025, but maybe in 2050 or 2075. Oil-rich countries need to be mindful of this. Resource rent is an opportunity for countries to develop their future economy, if they use these revenues wisely-sadly most do not.

Today, Saudi Arabia is in an excellent position to maximize its advantage; it should do so. Such competitive behavior exposes the weaknesses in the global economy, which is good for everyone. It is painfully obvious that most oil-rich countries need to get their house in order.

It is important to stress that Saudi Arabia has this advantage, not because it successfully diversified its economy (like Norway), but merely because it can produce oil from Ghawar much cheaper than the global average. If it can take advantage of this over the short term to increase its revenues over the long term, it should do so. That said, Saudi Arabia is not exempt from the diversification lesson, it too must work much harder, and smart, if it is to have a strong economy at the end of the 21st century.

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