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Trading Lessons

How Falling Oil Prices Could Trigger an "Unpredictable and Dangerous Mess"

Commodities / Crude Oil Sep 24, 2014 - 01:48 PM GMT

By: Money_Morning

Commodities

Dr. Kent Moors writes: The dive in crude oil prices continued yesterday as yet another selloff targeted the energy sector for a particularly big hit.

Of course, this too shall pass.

The crude oil markets are oversold and a rebalancing will bring prices back up a bit over the near term.


But the prospect of a protracted decline in oil prices is beginning to have broader policy implications in dangerous parts of the world, where rising prices have been the norm for most of the last decade.

I’m talking about what is going on in countries like Libya, where what’s underway now could become the standard for wider regional instability.

As this situation develops, it could quickly get downright nasty…

Three Reasons Why Oil Prices Are Falling

As it stands, West Texas Intermediate (WTI), the New York benchmark crude rate for futures contracts, has fallen 14.2% since its most recent high on June 19. London Brent also hit its most recent high on the same date, and has since fallen 15.8% through yesterday’s peg.

There are three reasons behind this decline.

First, unconventional crude production in the U.S., and unconventional and heavy oil extraction elsewhere in the world, has changed the supply side dynamic. Of course, these expectations will be revised as production rates change. But in the short term at least, the availability of shale oil is putting downward pressure on oil prices.

Second, this is also the time of year – between end of the summer driving season and the beginning of the transition into heating fuel for the winter months – when a decline in oil prices usually occurs. Only this year the decline has been more pronounced than usual.

Finally, and this is the truly unusual element, the presence of significant geopolitical tension is simply being discounted by oil traders. For instance, consider all of the uncertainties in the world today. A civil war and governmental paralysis has effectively taken all of Libya’s exports off the table. Iraq is in utter turmoil. And Ukraine is gearing up for the next phase of its crisis, since it doesn’t have enough energy in storage to meet the advancing winter.

Traditionally, a troika like this (combined with some smaller other events) would be enough to spike oil prices. In fact, that is exactly what happened in mid-June when all three of these crises seemed to collide.

Yet oil prices quickly retreated. Apparently, traders are not of the opinion, at least not yet, that the current geopolitical matrix is having a direct impact on the availability oil. Adequate supply side calculations, combined with some demand abatement, have only bolstered this approach.

Of course, going out further on the curve toward longer-term futures contracts does indicate some renewed concern about prices, and global demand is still climbing, increasing to the highest daily barrel figures we’ve ever seen. It is just not accelerating yet.

However, it could just be the lull before another tempest.

Nonetheless, end users are certainly welcoming the reprieve in prices. While the year-on-year difference in price is still higher, it is also tolerable by comparison. But the truth is these prices, while welcome, hardly classify as bargain basement pricing.

Even still, the longer we remain near the $90 level, the more likely it is that we will see a very standard response. Prices below anticipated levels will generate additional demand pressure.

Put simply, when energy is cheaper than expected, people use more of it.

As it stands, the current price of oil is well within the range analysts consider acceptable for continued economic development in price-taking markets (those dependent on others for their energy flow).

It is on the other side of the ledger where lower oil prices are beginning to cause major problems.

Where Lower Oil Prices are a Recipe for Disaster

In price-making countries, those nations that are in the export business, the current pricing environment is creating a policy nightmare. It’s not that the price of oil is too low. At $90 a barrel, all of these producers continue to make a nice profit.

That’s because domestic production abroad is paid for in local currencies, while the exports are purchased with hard currencies, namely the U.S dollar. That spread between the two allows for very cheap production costs and better proceeds on every sale.

Instead, the problem emerges in another way.

Rentier countries (those where the central budget is determined by foreign oil sales, not the development of land and economic diversification) are prisoners of the price oil commands on the world market. Since virtually everything else in these countries needs to be imported, declining oil prices add significant economic pressures.

By their nature, these rentier economies need to be able to design and administer multi-year spending programs based on projected oil revenues. Given their accelerating population growth, especially among the young for whom the unemployment rate is skyrocketing, and the inability to offset the energy sector with increasing revenue from other sources, planning in these economies becomes more difficult.

For the energy producers in the Middle East and North Africa, this is creating a mammoth crisis. One of the aftermaths from the “Arab Spring” has been an increase in government commitments to larger social and welfare programs, heavy internal subsidies on everything from gasoline to food, and an attempt to buy off rising dissent with governmental largess.

The important point is this: All of these promises require more than just the continued sale of oil.

They also require increased revenues from the sale of oil. In fact, several regional studies have already indicated that most Middle Eastern producers will require an average and sustainable crude price at least 25% higher than what is commanded today through 2020.

Thereafter, unless significant diversification takes place (and there are no tangible indications that will happen), the average price of oil needs to reach $130-$135 a barrel before 2025. And absent pronounced and deepening geopolitical pressures, the alternative supplies globally available would make these prices problematic, although possible.

As a result, here is the quandary facing the producing countries in a restrained oil pricing environment. Planning needs to be done in at least five-year increments. But the funds necessary to pay for those programs are very uncertain.

That has all the earmarks of rising internal political unrest. Each year the population becomes more reliant on central authorities, not the market. And a government can only buy an artificial domestic peace if the money continues to flow.

This is ultimately unsustainable – even if oil prices are rising. But in the current environment, a protracted narrow pricing range could easily translate into a dangerous and unpredictable mess like the one going on in Libya right now.

And Libya is just the beginning of this mess.

Over the past few days, the crisis hitting in Algeria looks like it has become “the new normal;” an inability to plan more than six months out because of uncertainty in oil prices and rising political demands from an increasingly frustrated population.

It’s a nasty mix that will eventually explode.

Source : http://oilandenergyinvestor.com/2014/09/falling-oil-prices-trigger-unpredictable-dangerous-mess/

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