A slippery slope: is the fall in oil price a good thing?

With oil prices plummeting at record speed we examine the positives and negatives of cheaper fuel
Commercial awareness
Business analysis

2008 has been an eventful year for the oil industry:

  • At the beginning of the year Shell, the Anglo-Dutch oil giant, recently announced the highest ever profit for a UK company (and a European company for that matter) of £13.9bn.Exxon Mobil, produced the highest profit for any company anywhere - $40.6bn.

  • The oil price peaked at an all-time high of $147 a barrel.

  • Recently, prices have fallen back down to a three and a half year low of $49, one of the fasted declines in history.

So why are oil prices currently so low?

Prices have always been known to fluctuate- typically between $30 and $60 a barrel during the post-war era. Yet the last decade has demonstrated a steady rise in crude oil prices. Over the last two years this trend has be exacerbated with prices doubling in dollar terms since 2006, peaking at $147 per barrel in July of this year. Since then, however, the price of oil has been plummeting - the price of a barrel of West Texas Intermediate (WTI) crude oil, which is used as the standard industry benchmark, current stands at a three and a half year low of $49, just over a third of its peak price barely five months ago.

The predominant factor behind this change has been a slowdown in demand.

Demand Factors

On a macro level, demand for oil has never been so high. Much of this increased demand is linked to the growing needs for energy from the developing world.

The last two decades have witnessed the economic emergence of previously under-industrialised nations. The rapid industrialisation of countries such as China and India is a necessary step if these nations are to catch up with their western counterparts on an economic level but is only made possible when fuelled by the necessary commodities: metals, gas, minerals and oil.

Nowhere is this more evident than in China whose oil consumption doubled between 1996 and 2006 as it undergoes a period of aggressive economic and industrial growth. Having been a largely self-sustaining economy up until the end of the last century with little need for importing commodities, China now finds itself as the second largest consumer of oil in global terms, consuming almost twice the amount of oil it is able to produce.

Despite the rise in consumption within new markets, however, the developed world still accounts for the lion's share of the world's consumption. Of the top ten global consumers, only three nations can be classed as 'developing'.

The United States alone accounts for 25% of all oil used around the globe. Though next on the list, China's consumption accounts for a relatively modest 8.5%, despite having four times the population of the United States. Whilst this imbalance will undoubtedly change during the course of our lifetimes as Asia's citizens move increasingly into adopting Western lifestyles, in the short term the continent's bearing on consumption levels is relatively insignificant in contrast to its counterparts in Europe and North America.

In the US, the drop in oil consumption has been especially marked given that the country's population has a reputation for being blasé in regard to the quantities of petrol and fuel they use day to day. The drop in overall consumption in 2008 has been 5%, the fasted fall since 1981 and a figure which, given the country's distorted influence on world consumption levels, has had a noticeable effect on the pricing of fuel on a global scale.

But why is this? The recent high prices have been felt by US citizens to a greater degree than they are in Europe where fuel tax makes up the majority of the price passed on to consumers. To put it in perspective, the total tax paid on a gallon of fuel in the UK, including VAT, is $3.80. The average across the US's states is $0.47, less than an eighth of what UK drivers pay. When the global price of oil rises by 100% as it did between mid 2007 and 2008, the effect on US consumers was far more noticeable than it was in the UK and other EU countries.

Americans are cutting down on the amount they drive, fly and use other fuel-hungry devices such as air conditioning and garden mowers more than ever before. Other factors are also contributing, not least the fear of recession which is at the forefront of the minds not only of US citizens, but of those across the Western world. As business output and consumption levels have fallen over the past two months, so to have the prices of raw materials and food, reversing the inflationary trend of the first half of the year. Car usage, which has always been proportionally high in the United States, has shown a huge decline in recent months as households have looked to make cutbacks to their budgets- you only need look at the bankruptcy crisis facing general Motors and the country's other major car manufacturers.

Lastly, there is more competition than ever towards fossil fuels usage from alternative forms of energy such as solar power and bio-fuels. Whereas solar panel and wind energy installations may have been prohibitively expensive for the average home-owner a few years ago, individual consumers in the US are having the choice between paying up front to install solar panels that should last 20 years, or facing the prospects of having to shell out on ever increasing energy bills over that period. Likewise with energy-efficient cars and petrol costs.

Fundamentals vs. Speculation

The forces described above are real - i.e. they represent fundamentals - real demand and real supply of actual oil stocks. However, there is a second array of forces - speculation by traders - which also have a major bearing on oil prices.

Traders anticipate fundamentals and anticipate other traders' actions too. They exploit imbalances between different prices and forecast where they think the oil price will be in the future. If they think the market price of oil will rise in the future, they will take a position - buying actual stocks or more likely a futures or options contract.

The volume of speculation in world markets has a huge bearing on the price of oil paid by manufacturers and consumers. Recently as economic data coming out of the US and Europe has been more negative than first expected, traders have taken the opposite route of shorting the price of oil in the expectancy of further fall.

Political Reaction

The amount of oil available on the market is strictly controlled by governments and international agencies, amongst them OPEC, a collaboration of Middle Eastern, African and South American oil producing nations who look to safeguard their future income from oil production by limiting the supply made available to consuming nations.

The reaction from the group to the drop in price has been one of grave concern. For many nations, such as Angola and Venezuela, oil revenues make up the majority of their national incomes. Oil price increases over the last few years have transformed the prospects of smaller nations, like Angola, who have been able to invest the revenue from sales in much needed areas such as infrastructure. Representatives from the 13 member nations met in Vienna in October to discuss how to cap the fall. It was decided to reduce oil production across the member states by 1.5 million barrels a day, limiting supply so as to boost the relative demand and with it the price per barrel. So far the decision has appeared to have had little effect as prices have since dropped even further.

Pros and Cons of the oil price drop

So is the drop in oil price a good thing? Our immediate reaction would be yes. Lower oil consumption is good for the environment, good for depleting oil reserves and not least good for the average consumer who has to heat their home and get from A to B.

At the same time, however, low fuel prices can be seen as a double edged sword. When prices are low as they are know, people have less incentive not only to switch from oil and gas to alternative forms of energy which appear more expensive, more worryingly there is less emphasis on an institutional and governmental level in putting money and expertise into new areas of energy such as bio-fuels. Despite breakthroughs made into bio-fuels and methods of renewable energy in recent years, the industry is still at an embryonic stage of development. Across the world, so far only Brazil has made the successful leap to using bio-fuel blends to run its cars. As people get more cash conscious following the onset of the recession, they are less likely to investigate the longer terms alternatives presented to them if they don't immediately appear to be saving them money. This change in outlook has forced several bio-fuel producers in the US to fold in recent weeks as they are increasingly unable to compete

Already mentioned are the smaller oil-producing countries which stand to be affected by the price drop, but another significant loser are the oil companies themselves. Major oil firms like Shell and BP set their budgets on the assumption that future prices would remain stable around the $80 - $100 mark. They have stated that they are able to break even whilst oil prices remain above $60 a barrel. If they fall any lower, as they have done, they will start to go into the red. Whilst it is unlikely that the majority of people will be crying themselves to sleep at night at the prospects of hard up oil barons, particularly given the bad PR they generated when posting record profits at a time when consumers were being hardest hit by record prices.

Falling revenues have much longer lasting and more severe consequences that the quarterly bonuses collected by oil firm executives, however. The dramatic drop in income in recent months on the back of falling prices has led most companies having to make considerable cut backs in planned oil extraction projects. Oil extraction is an extremely cost-heavy business, particularly when the majority of sites still t be developed lie in hard to reach areas under the sea bed or in the mud flats of Canada. This means that rather than sourcing and developing new sites for oil extraction which could boost supply in the future, existing reserves are being drained with out any recourse to new sites once these dry up. Paradoxically, by having low oil prices now we are only ensuring they will be even more expensive in the future as supply constraints which could otherwise have been eased are not being so. Another harmful consequence is that companies like Shell and Exxon pumped billions of Pounds into research into developing sustainable energy sources each year. With large scale budget cuts, these areas of investment will likely take huge hits over the coming months.

Outlook for the future

How low can they go is a question posed by many people directly affected by swings in oil prices. A recent meeting of the national oil companies in Beijing predicted that prices could fall as low as $40 per barrel during the current downturn, exacerbating the problems described above.

Looker longer-term, however, the only way is up. It will only be a matter of decades before countries like India and China reach western levels of consumption and when they do there is no telling how rare and expensive a commodity oil could become. With most current reserves having passed their peak point of productivity, the only lessening factor in the long-term will be how far new areas of extraction and alternative fuels can boost supply. With little investment being put into these areas at present, the prognosis is not good. One thing is certain, as long as world population growth shows no sign of slowing down and poorer nations seek to develop there will be demand for energy and for oil. How long the planet can keep producing oil at the levels required, however, is anyone's guess.

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