The collapse of oil prices

Rafael Pampillón. Professor. IE Business School

15 January 2016

History shows us that falling oil prices caused by excess supply lead to cutbacks in prospecting and extraction that lead to prices going back up again.

Oil prices are at their lowest in 11 years, and are still falling. This is good news, because low oil prices is one of the factors that is most helping to drive economic recovery in Europe and Spain. In the first nine days of January the price of oil fell by 10%. The causes are well known: Abundant supplies of oil worldwide, low demand (due mainly to China’s economic crisis) and large oil reserves in the US. Added to that there is the strength of the dollar. Oil prices have been falling for a year and a half now, while the dollar has been steadily rising. This is no coincidence. Given that the price of oil is set in dollars, oil producers, who are being paid in an increasingly strong currency (the dollar), can use this advantage to offset losses resulting from falling prices.

Perhaps one of the causes of the fall in the price of a barrel of oil is the appreciating dollar. This virtuous circle benefits Spain and other European countries that import oil, given that their citizens are able to free up some of their disposable income used to pay for transport and energy and save it or spend it on other things. Moreover companies now have lower energy costs, which means more profits that can be used to fund themselves. The appreciation of the dollar brings another benefit for Spain, namely that it makes Spanish exports cheaper compared to US products. In short, it is a scenario that favors higher levels of consumption, investment, and exports, which in turn generate more well-being and employment.

Future outlook

Nearly all analysts forecast that there will not be any massive variations in the price of petroleum over the course of 2016, given the major imbalance between an enormous supply and scarce demand. The addition of Iranian oil in 2016, following the recent agreement, will place more pressure on the supply side and will keep prices low. Furthermore, the break in diplomatic relations between Iran and Saudi Arabia is going to make it difficult to establish agreement among the OPEC countries to reduce production.

Nevertheless, extremely low oil prices could mark the beginning of a cycle that has recurred throughout history with some frequency - the collapse of oil prices caused by excess supply leads to cuts in investment in prospecting and extraction of oil, which means levels of production fall and prices are pushed back up again. Oil companies have been through this cycle several times. The last time was in 2008 and 2009. In less than a year prices fell to a record low from 146 dollars a barrel in July of 2008, to 34 dollars in February of 2009. As from March of 2009, however, the price of black gold began to climb again until it reached 120 dollars in 2012. This rise in the price of energy, which started half way through 2008, had a very negative impact on the world economy, which was already in decline due to the onset of the economic crisis.

Oil prices will go back up one day

History is yet to be written, but it looks likely that the price of petroleum will go back up. What we don’t know is when. It could be after a few months, or after a few years.

At the beginning of January, the Wall Street Journal published the news that some 150 oil investment projects had been halted worldwide, which means the indefinite deferral of the production of approximately 13 million barrels a day. This equates to 15% of total world production. New projects are also being postponed, like the exploitation of bituminous sand deposits in Canada and deep waters in the Gulf of Mexico, Africa and in the Arctic, where oil extraction is particularly expensive. However, there is also a lack of investment needed to offset natural depletion of oil fields over time in places like Argentina, Venezuela, Mexico, Algeria and Nigeria.

Oil prices could also go up if a reduction in supply is coupled with an increase in demand, and that will happen when the world economy improves again. That would require higher levels of growth in China and other emerging economies, and that is going to depend on the Chinese authorities being capable of inspiring trust in their new fiscal, monetary, and regulatory measures, and on the rate of currency exchange.

Hence, within an amount of time that is very difficult to predict the price of petrol will rise again, which will unfortunately force down rates of economic growth in countries like Spain. These possible rises in oil prices could result in less economic growth coupled with inflation. In this scenario, the risk of deflation in Europe and Spain would disappear precisely thanks to the rise in energy costs, but also due to the enormous levels of liquidity produced by expansive monetary policies, tax cuts and high levels of public spending. So much has been done to avoid deflation that it means that inflation is almost inevitable in the medium term.

Nevertheless, in the short term there is no danger of inflation. On a global scale, deceleration of emerging economies, excessive surplus production capacity, and unemployment of part of the active population makes it almost impossible for companies to raise prices, or for workers to have wage increases. In the medium term, with higher prices of barrels, it is possible that we may see low growth and inflation in Europe. This would make the tasks facing the European Central Bank rather more complicated, and would mean it would face a dilemma. In order to reduce inflation it would have to raise interest rates and withdraw the enormous amount of liquidity generated in recent times, but if it did that it would stymie the tentative economic growth achieved so far by European economies.

But until all this actually happens, we should make the most of low fuel prices. Effectively China’s low levels of demand for raw materials, the lack of agreement among OPEC countries and the rise in supply from US oil-shale producers, points to a prolonged cycle of low oil prices. Europe will, without doubt, be the world region that benefits most. We may as well enjoy it while it lasts.

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