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No Conspiracy Theories Needed to Explain the Oil Plunge

Forget elaborate Saudi theories. Think mundane things like the slowdown in global economic growth

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This article originally appeared at Global Economic Trend Analysis

In the wake of a widely unexpected, huge oil price decline, I have received many questions and comments.

Some speculate US pressure on Saudi Arabia to punish Russia. Others think "big oil" is out to punish the frackers.

I responded to a friend today that the explanation is simple. No conspiracy theories needed. This was my proposal.

Explaining the Plunge in Oil

  1. Slowing global economy, especially China and Europe
  2. US production expansion
  3. OPEC pumping above quotas – they all cheat
  4. Iran embargo failing
  5. Increased fuel economy
  6. Attitudes of millennials towards cars and driving

I give heaviest weight to number one, but they all cascade.

To maintain revenue with US producing more of its own oil, OPEC members cheated more to maintain revenue. Increased fuel economy and attitudes of millennials are longer-term factors, but they become more important as demand drops due to the slumping global economy. 

Discarding Conspiracy Theories

I am a big fan of Occam's Razor, a principle that suggests the simplest workable explanation is likely to be the best one. (For a tie-in to bank lending, please see Occam's Razor and Bank Lending.)

In this case, a slowing global economy thesis is a far simpler explanation than the notion that the US pressured Saudi Arabia and OPEC, and both of them agreed to cooperate, simply to punish Russia at the request of the US. 

Did that happen? Not likely!

OPEC and or "Big Oil" attacks on frackers are equally ridiculous for exactly the same reason.

Reflections on the Price of Oil 

Just minutes after I responded to my friend, a contact emailed an interesting report on "The Price of Oil" by Dieter Helm.

Helm dismisses peak oil, I don't (and to a certain extent he misses the construct), but much of the rest of what he has to say is accurate enough.

Helm states "Around the world high prices triggered the search for new supplies." 

That's certainly a true statement, but in the next breath he states "It has turned out that the earth’s crust has plenty of oil and gas left, that R&D is not confined to non-fossil fuels, and that there are physically abundant supplies for decades to come. The problem is not an imminent shortage of oil and gas, but rather a super-abundance, enough to fry the planet many times over." 

The idea of a "super-abundance" of oil is ridiculous. The US saw an increase in production not because there is abundant supply, but rather because prices got high enough to make diminishing supply profitable to exploit. After all, that's what peak oil is about.

And with this plunge in oil, new development has come to a halt. Many of these drillers are not profitable at these prices and huge numbers of bankruptcies will result.

OPEC to the Rescue?

Helm is on target with comments regarding OPEC. 

It is claimed that OPEC will come to the rescue. Since the oil producers have squandered the revenues from the price increases, they now need high prices to keep on buying off their populations, especially in the Middle East where Arab Spring revolutions in several countries has scarred authoritarians and dictators.

It is claimed that many of the key players need a price of $90 a barrel or more. The idea that because of the waste and corruption and populist spending, these countries can therefore enforce a particular price on the market is nonsense.

A price can only be imposed if they all agree, they all actually cut production and the consequences of their behaviours is not to cut demand and increase non -­‐ OPEC supplies. None of this is likely to be true.
The first point to note is that OPEC’s market power is waning. The US (and North American) production has transformed the market. The US is still over 20% of global GDP. Half its trade deficit was oil and gas.

Now the US and the rest of North America are well on their way to rough energy balance. That is an enormous withdrawal of demand from OPEC.

Europe is also reducing demand and economic growth is flat. China is slowing down and developing alternative supplies.

It is now much harder in theory for OPEC to call the market. But even if it did want to fix the price, the mechanics are also a whole lot harder than they were in the 1970s, the last time it really had much impact. 
There are two myths about OPEC.

The first is that Saudi Arabia can on its own increase or decrease production enough to make a difference.

This is true now only in the very short term, and it would have to make a really big reduction to offset other increases, it would make a big hole in its budget and the result would be to encourage an even faster diversification away from it, notably by the U.S. 
Second, the fracking genie is out of the bottle. Lots and lots of countries will apply the new technologies. Some of this will be gradual and largely unnoticed outside the industry. More will be got from existing conventional reserves, and gradually new reserves will be opened up. There is no shortage of shale reserves around the world.

It is highly likely there are substantial shale reserves. But at what price point cost-wise do they make sense to develop? And what about pollution costs and environmental cleanup? 

All of this has come together now in the perfect storm for oil producers.

Winners and Losers

The winners in this oil selloff are generally oil importers. The losers are the exporters.

The Financial Times has this interesting graphic of Winners and Losers of Oil Price Plunge

Big Winners

From the above graphic it would appear that Europe is the big winner.

Falling oil prices enable producers to pass on lower prices for the benefit of consumers and producers alike. One would never know for all the European bitching and moaning over price deflation.

Nonetheless, the biggest winner in all of this is Japan, not Europe. Falling oil prices are the one thing that has saved Abenomics from complete disaster. 

Big Losers

The biggest losers are easy enough to identify, but the chart has it wrong as Saudi Arabia.

Arguably the two countries most punished by falling oil are Russia and Venezuela. The latter I expect to default sometime in 2015.

The Financial Times notes one of the ironies in this mess. "As late as October, a 'key concern' of the International Monetary Fund was the risk of an oil price spike caused by geopolitical tensions. Instead, rising production and weaker demand growth have left suppliers competing to find willing customers."

As usual, the IMF worries about the wrong things with a perpetually overoptimistic view of the global economy.

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