A Thursday in Vienna

3 December 2014

Last Thursday, OPEC (Organisation of the Petroleum Exporting Countries) met in Vienna to address the issue of falling oil prices. Despite the wishes of many of the member countries, Saudi Arabia effectively blocked any call for a reduction in output to arrest a slide in global prices.
Why have oil prices tumbled?

Oil prices have tumbled because there is a surplus of oil. The surplus has three components:

  1. Economic stagnation in Europe and Japan have reduced demand.
  2. The production of oil worldwide has increased. In the United States the steady increase in shale oil – in the last six years shale oil output has increased by 4 million barrels per day – together with significant increases in output from Libya and Iraq have significantly increased the worldwide supply of oil. The volumes are not insignificant. The increase in US shale oil production is greater than the entire production of any of the OPEC countries excluding only Saudi Arabia.
  3. In the past Saudi Arabia has played the role of swing producer in OPEC balancing the total output by altering its own production levels. Clearly it no longer wishes to do this and is in a position to weather lower prices in order to maintain its market share.

Why is Saudi Arabia allowing prices to slide?

Apart from wishing to maintain market share; the world is changing. People are more energy-conscious and governments are increasingly looking at alternative energy supplies. Protecting market share in a period of shrinking demand makes good commercial sense especially if it “puts the squeeze” on higher cost producers.Over the past three years Saudi Arabia has gained significant market share which it is unwilling to sacrifice to help some of the other members in OPEC. There may be other factors at play since Saudi Arabia is unhappy with the support Syrian President Bashar al-Assad has received from other members of OPEC and Russia.

How low can it go?

Few commentators expect prices to fall as low as US$60 and most expect in the short-term prices will settle at around US$70 before recovering in the second quarter of 2015 as a new equilibrium in markets finally arises.

The effect of falling prices on the shale producers of the United States

Many analysts believe that by choosing to maintain output levels,OPEC (and in particular Saudi Arabia) is trying to slow down the shale boom in the United States by making drilling less profitable.If this is the case, the strategy is unlikely to succeed. At a price of US$70 per barrel, over 80% of shale production in the United States remains profitable and in any case a lot of the production is hedged against significant price falls.

Who in OPEC is suffering?

Ok, so Russia isn’t in OPEC but this photo of a ‘possibly-not quite-probably not-but still!’ teary Putin was made for this blog report!

Both Venezuela and Algeria are suffering and wanted their OPEC partners to reduce output by as much as 2
million barrels per day. Iran is also suffering since its national budget is based on a much higher oil price than the current market price.

Add to this Russia (not currently a member of OPEC) but a significant producer (4 million barrels per day) who estimate that the fall in prices over a sustained period will cost the country as much as US$100 billion in revenue, an amount that is more than twice it is losing currently as a result of sanctions arising over its stance on the Ukraine.

A word for those holding Venezuelan Bonds – “Hang Tough”

With oil accounting for approximately 96% of export earnings and 48% of the government’s budgeted revenue, the ability of Venezuela to service its foreign debt will be tested over the next six months as oil markets settle into a new equilibrium.

Whilst it is true that there are countries that generate a larger proportion of their budgeted income from oil (two examples being Saudi Arabia and Russia), Venezuela is far more vulnerable to economic fallout resulting from depressed oil prices given its weak financial position.

Russia has reserves of $400bn and Saudi Arabia $765bn. Venezuela has just $21bn. The numbers are bleak and they don’t lie.

However Venezuela does have options. It could continue to cut public imports and it could choose to devalue the bolivar and raise gasoline prices internally. There is also the option to reduce shipments to Petrocaribe. At US$60 per barrel Venezuela should be in a position that it can – with sacrifices that will continue to hit domestically – service future bond payments as they fall due.

Beyond this, default is just not an attractive or viable option for the Venezuelan government. The bonds are well secured and were Venezuela to default bondholders will be able to seize the country’s refineries and oil shipments.

The smart advice for those holding Venezuelan bonds is not to panic, take a long-term view, and continue to “hang tough”.

The Position in Trinidad and Tobago

The budget of Trinidad and Tobago is predicated on an oil price of US$80 per barrel and a gas price of US$2.75 per mmbtu of which reportedly 75% goes to oil indexed markets for gas.To the extent that oil prices are lower, government revenue will be reduced if the shortfall is not picked up elsewhere by increasing revenue from other sources. Trinidad & Tobago has US$10 bill in reserves and an oil stabilisation fund, and the government has revealed that it is looking at cutting expenditure as well as assessing elements that can be delayed or deferred.

The impact domestically should be manageable unless the price of gas and other related derivative commodities also begins to decline dramatically.

The Rest of the World

For the rest of the world lower oil prices are surely great news. Lower oil prices could revive global demand since lower fuel prices at the pumps effectively act as a tax cut for consumers. As disposable income increases in most cases spending and economic activity in general increases.
For the stagnating economies in Europe and Japan and the stuttering economy of the United States this has to be good news.

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