Tuesday, January 27, 2015

More on the oil price declines

Daniel Yergin points to two stunning factoids about the recent history of oil prices. First, about the standout winner,
By the end of 2014, oil production in the United States was 80 percent higher than it had been in 2008. The increase of 4.1 million barrels per day was greater than the output of every single OPEC country but Saudi Arabia... This revolution also turned out to be a big boost for the American economy, creating jobs, improving the country’s competitive position and drawing in over a $100 billion of new investment. Only rarely has the global oil market seen production increases on this scale this fast. The last time was in the early 1980s, when new supplies from Mexico, the North Sea and Alaska created an oil surplus that led to a price crash.
Second, the losers,
Over all, the fall in oil prices could mean a $1.5 to $2 trillion transfer from oil-exporting countries to oil-importing countries.
Just as the higher oil prices engendered a shale oil and gas boom that boosted the US economy, the declining prices threatens to damage the economy. Times reports that drilling firms are decommissioning rigs and laying off workers and companies that leased equipment have fallen behind in their payments,
Since the Permian Basin rig count peaked at around 570 last September, it has fallen below 490, and local oil executives say the count will probably go down to as low as 300 by April unless prices rebound... Unlike traditional oil wells, which cannot be turned on and off so easily, shale production can be cut back quickly, and so the field’s output should slow considerably by the end of the year.
And Jim Hamilton, the foremost authority on the economics of oil markets, had this to write about the demand-supply dynamics,
Field production increased worldwide by only 2.3 mb/d between 2005 and 2013. That compares with a predicted increase of 8.7 mb/d from extrapolating the pre-2005 trends in consumption growth for developed and emerging economies, and that’s without even taking account of the dramatic acceleration in demand from the emerging economies... According to the 2014 IMF World Economic Outlook database, world real income increased by 27.7% between 2005 and 2013. If we assume an income elasticity of 0.7, for which Csereklyei, Rubio, and Stern provide abundant empirical support, we would have expected that in the face of a stable price of oil, production should have increased by 19.4%. The actual increase in field production of crude oil was only 3.1%, consistent with a shortfall of 12 mb/d.
Apart from demand-supply dynamicsJeffrey Frankel points to how real interest rates may be affecting real commodity prices. He identifies four channels whereby high real rates reduce the price of storable commodities - increases incentive for extraction today rather than tomorrow; lowers desire to carry inventories; encourages money to shift out of commodity contracts into treasury bills; and strengthens domestic currency, thereby reducing the price of internationally traded commodities in domestic terms.

He feels that the fourth channel has had an important role to play in the recent decline in oil prices. Since most oil contracts are dollar denominated and since the dollar has appreciated against all other currencies, it is only natural that it has weighed on the decline in dollar price of oil. The graphic below is illuminating.

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