The future is past: Between 2014’s oil prices and the days of yore

As the year closes, one of the most far-reaching events has been the extreme drop in the global price of oil

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It goes without saying that 2014 has been a tumultuous year, with geopolitical conflicts in Eastern Europe, the Middle East, Africa and elsewhere. The deadly spread of Ebola throughout West Africa has incited fears that humanity could be on the cusp of a global pandemic. However, as the year closes, one of the most far-reaching events has been the extreme drop in the global price of oil.

At the time of writing, the price had slumped below $60 per barrel. This is the first time since May 2009, during the global financial crisis, that the oil price has dropped so low. It is too early to say how long the decline will last, and what the impact will be on oil-producing countries. However, we have historical precedent to structure our understanding of what will be the likely outcome.

One of the most consequential oil-price collapses in recent history occurred on April 1, 1986, when the price of West Texas Intermediate fell to below $10 per barrel. This price collapse was mainly due to a global oil glut and massive production increases from some of the world’s major oil producers.

One of the principal reasons for the vast expansion in oil production was market share competition among exporters. The result of this cutthroat rivalry was a disastrous race to the bottom, as each producer attempted to export as much as possible to grab market share from competitors.

To a certain degree, market-share competition could be compared to a term used in economics, “the tragedy of the commons.” This describes how individuals, groups or countries acting solely out of self-interest harm the collective economic interest. There have been groups formed to counter this phenomenon, such as the Organization of Petroleum Exporting Countries.

However, it takes a significant amount of self-control to overcome the urge to benefit from the collective restraint of others. Many critics malign the role of OPEC in managing oil output among its members, saying that goes against the principles of free-market competition. However, when OPEC is strong and united, it brings stability to the oil market, which helps all producers, not just OPEC members.

In most cases, oil-producing countries act in fairly predictable ways when confronted with a significant price decline. At first, they try to gain market share to shore up their economies at the expense of their rivals. However, as the situation progresses, they tend to collaborate with each other to mitigate the brutal economic effects of their production rivalry.

Economic absorption

Oil-price collapses tend to disproportionately impact a certain type of oil-producing country. Those that feel the brunt of a price decline are known as “high absorbers,” which have relatively large populations and small per-capita oil reserves. The result of the glut on the global market and the price crash of 1986 proved particularly disastrous to the economies of these high absorbers, such as the Soviet Union.

For the most part, the Arab Gulf oil-exporting countries were able to weather the storm. They are known as “low absorbers,” with smaller populations and large per-capita oil reserves. The concept of absorptive capacity is essential to understanding how energy-rich countries are able to domestically utilize foreign revenue gained from oil and gas exports, and how they manage a stark price decline.

This concept also concerns the lack of profitable domestic investment opportunities for countries with high government revenue from energy exports (principally oil). Understanding this distinction assists in conceptualizing the policy choices available to oil-rich countries given the current price decline.

However, what distinguishes the current decline from previous ones is the policy space available to the major producers, such as Russia, Saudi Arabia and the United States. Russia, facing the dual impact of Western economic sanctions and a decline in foreign revenue from oil sales, has seen its currency sharply devalued while its foreign currency reserves shrink.

Heading into 2015, it is increasingly likely that the mid-January Standard & Poor’s credit-rating review of Russia will downgrade it to “junk” status. This would have a detrimental effect the country’s strategy of exerting its political will on its neighbors, as well as President Vladimir Putin’s domestic popularity.

The Arab Gulf states, while economically healthier than Russia, are in a significantly different position than they were during the price slumps of the mid-1980s and late 1990s. They have since had large population increases, and a rise in government expenditure on infrastructure investment and the welfare apparatus.

This caused the breakeven price - the price a country needs to obtain for a barrel of oil to remain economically solvent - to nearly triple over the past decade. The rise in the Gulf breakeven price has caused these countries to have reduced immunity against low oil prices, and so are in a much weaker economic position to weather extreme price volatility.

Despite the rise in the breakeven price, OPEC has pledged to remain steadfast in its production target of 30 million barrels per day, and according to statements from leading oil ministers of member states, even if the price drops to $20-$30. What is evident from the OPEC response is that countries with higher production costs, such as the United States, will have difficulty maintaining or increasing output.

The United States has made headlines with its giant leap in oil production from its shale reservoirs. Still, the shale boom obscures the profoundly ambivalent relationship that the United States has managing its role as one of the world’s largest oil producers with its position as a global manufacturing power.

It undoubtedly benefits from a low oil price, as the average American consumer will pay less for transported goods and at the gas pump. As evidenced by 5 percent economic growth in the third quarter of 2014, low oil prices are already spurring U.S. economic recovery.

However, it is also harmed by price decline. The major producing states in the U.S. rely on oil revenue taxes to fund their annual budgets, therefore the recent price declines portend tough times ahead. These states had factored into their spending projections prices above $100 for the fiscal year of 2015. Much like the high absorbers, in the face of a protracted price decline they will either have to reduce spending or raise taxes, perhaps both.

Longer-term risks

If prices remain low for the mid-to long-term, oil producers will scale back investment in new fields and shutter less profitable ones. This would negatively impact investment in new wells to either maintain or boost American production.

The fact that nearly all major oil-producing countries cannot bear a low price for the mid-to long-term will force at least the major OPEC producers, and perhaps Russia, to reduce output in a bid to contain the price slide.

The sharp price decline over the past year does not bode well for either American or Gulf oil production. U.S. oil companies cannot sustain a long-term price decline in fields that require an average price of $50-$70 per barrel to remain profitable. In the Gulf, while operating costs are among the lowest in the world, because of expansive entitlement programs these governments require $80-$100 per barrel to remain fiscally solvent.

While OPEC has pledged to remain resilient in the face of declining prices, if they continue downward, the world’s major oil producers will eventually blink and move to stabilize the global price by reducing output. A return to $20 a barrel is an option that no producer is willing to tolerate.

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