Back to overview

Commercial Question

Oil prices and the future of ‘black gold’

updated on 03 November 2020

Question

Why are oil prices still crucial to the global economy?

Answer

You might be forgiven for questioning why oil prices continue to attract so much newspaper ink. After all, oil is increasingly decried as a dying industry hell-bent on harming the planet. Further, the RAC and the AA commonly complain that price fluctuations are not reflected on the forecourts that the public actually visit every day, thanks to a cocktail of taxation and profit margins built into supply chains.

Despite the preponderance of such views, oil prices continue to be of crucial importance to the global economy. This article seeks to demonstrate why this is so. To illuminate the issue, we will first consider what drives oil prices.

The relationship between supply and demand is the cornerstone to understanding oil prices. When demand rises, prices will also rise (assuming supply remains constant). When supply rises (assuming demand remains constant), prices will fall.

Supply is affected most by:

  • the activities of OPEC (the Organisation of the Petroleum Exporting Countries), a cartel made up of 14 countries that export petroleum. These nations have come together to control the price of oil by manipulating supply. They regulate by quota. Their nightmare is a price war resulting in the depletion of their national reserves. Their influence has waned following the reinvigoration of the US energy sector following the rise of fracking (crudely, a process which involves firing a high pressure water mixture into rock to release gas trapped inside, allowing access to difficult-to-reach resources). OPEC’s heyday came in 1973 when its supply restrictions led to an explosion in the oil price (termed the ‘oil crisis’). OPEC’s demise should not be overstated: its member countries still reportedly control almost 80% of the world’s supply of oil reserves;
  • non-OPEC oil producing countries, including Canada, China, the United States, and Russia (though the latter often ‘cooperates’ with OPEC); and
  • exogenous shocks, such as the assassination of Iranian general Qasem Soleimani, Hurricane Katrina, or covid-19. These are ‘unpredictable’ events that eluded prognosticators in their forecasts. Other examples include natural disasters, geopolitical instability and war.

Demand is affected most by:

  • the strength of the global economy. All things being equal, the worse the state of the economy, the lower the demand for oil and the lower the oil price. After the 2008 crash, the price of Brent Crude fell in excess of $100 a barrel in five months. Brent Crude is the most commonly used of the three major oil benchmarks: the others are West Texas Intermediate (WTI) and Dubai/Oman. Oil benchmarks are a shorthand so that oil traders know which type of oil they are trading: Brent crude, for example, is defined as crude mostly drilled from the North Sea oilfields. It is traded so frequently because it can be transported easily (as it is produced at sea) and because it can be refined easily into diesel and gasoline (because it is light and sweet);
  • alternative energy sources, such as nuclear, solar, and wind. If renewables are widely available and cheap, oil demand will likely falter;
  • the strength of the US dollar. Oil is exchanged in US dollars. If the dollar becomes stronger, the price of oil will tend to drop and if the dollar weakens, the price of oil will tend to rise; and
  • market speculation, predominantly through the use of ‘futures contracts’. Under futures contracts, buyers and sellers agree to deliver specific amounts of physical oil at a predetermined price on a given date in the future. Participants in the futures market speculate on the effect of events on the oil price.

Note that these serve only as a short summary of the main potential influences. Other factors from costs of production to interest rates are also commonly cited (and debated) as influencing the oil price.

To see how this plays out in practice, consider the recent crippling lows reached in the oil market: these were the biggest drops since US forces launched air strikes against the Iraqi military after the invasion of Kuwait in 1991. In 2016, OPEC and Russia came together to form the ‘OPEC+’ alliance to carry out supply cuts: oil was at $30 a barrel and they wanted that figure to rise. This relationship proved fractious: Saudi Arabia wanted to maintain a restricted supply, but Russia did not, in large part because it did not want to cede market share to US producers.

It costs US shale producers far more to produce oil than it costs Saudi Arabia or Russia, but the United States has nevertheless become the largest oil producer in the world. Years of wrangling over production restrictions spilled over and Russia declared it would break from the agreement starting 1 April 2020.

Saudi Arabia responded to Russia’s refusal to play ball in a surprising way: it too cut its prices and boosted production. Previously,. when Russia had undermined the alliance, Saudi Arabia had reluctantly cut its own output sharply to shore up global oil prices. This had been the worst of both worlds: oil prices were high enough to make US shale viable, but were insufficient to balance the budgets of most petrostates. Simultaneously, covid-19 was running rampant, decimating global oil demand, but particularly in China (the world’s largest oil importer).

The collapse in the oil price was seismic: at the beginning of May, oil prices ‘turned negative’. Oil is traded on its future price. The ‘negative oil price’ signified that oil producers were willing to pay purchasers to take oil from them as they were so concerned that there would be no storage space available at the end of the month. The price of hiring oil tankers soared as people rushed for somewhere to park the oil soon to be delivered. This storage shortage was caused by the heady mix of no demand for the amount of oil that was being supplied. Subsequent attempts to cut production were insufficient given the extent of the glut. Granted, the ‘negative prices’ related specifically to WTI futures contracts for the month of May, but the significance of this development should not be underplayed: this was the first time the price of US oil had turned negative in its history.

So what? Why is oil price more than an abstracted poker chip for traders? Oil prices matter because they, among other things:

  • dictate government spending for oil-producers around the world. These countries often rely on certain oil prices to balance their budgets: while Russia can finance its budget with oil at just over $40 a barrel, Nigeria relies on a price of $57 a barrel and Saudi Arabia requires a price of over $80, despite having average costs of production at roughly a third of the United States’s. Countries as varied as Iraq, Algeria, Bahrain and Venezuela will see their finances detonate yet further. Consequently, they will be incapable of investing in healthcare or education, and will find it very difficult to borrow further: a sizeable proportion of their existent revenues is spent on servicing debt. These debt loads have marched steadily higher ever since oil prices began to tumble in 2014. Printing money is rarely an effective solution in the end, as past Zimbabwean governments have convincingly proved. Despite plenty of talk about ‘diversification’, many oil-producers only have tourism as a reliable alternative to oil. So far, this has not fared well since the covid-19 outbreak;
  • affect the costs of production and manufacturing in the global economy. Plane tickets will continue to be affected by fuel prices, even if some may struggle to believe that aviation will make a full recovery in the next couple of years. Industrial chemicals are refined from oil and prices affect manufacturing. Perhaps less obviously, oil is used in plastics, clothing, furniture, insulation and so on. Despite this, the relationship between the oil price and the economy at large is far from linear: just because the price hikes of the 1970s and 1990s contributed to recessions and moved income from ‘the West’ to Middle Eastern oil producers, does not mean this relationship will always persist, nor that falls in price lead to economic booms. Economies are no longer so dependent on oil. The situation is nuanced, for example, many oil producers boost spending when the oil price soars. When prices drop, an important element of global demand can also fall away;
  • are inextricably linked to job prospects – not only drilling crews and mechanics, but satellite businesses in oil producing regions too: from restaurants to car showrooms. There are also profound knock-on effects. Remittances comprise 9% of Egyptian GDP, with over half of Egyptian expatriates working in the Gulf states; and
  • exert great influence on the banking and investment sectors. This applies to many pension funds, not just speculators. Take the credit markets as an example. Following the oil price implosion, almost 70% of the speculative grade debt in the oil and gas industry is at ‘distressed’ levels (this means that the bonds have spreads of more than 10 percentage points compared to US Treasuries). This should be of interest to anyone with a bond mutual fund, let alone a high yield bond mutual fund.

Predicting the future of the oil price is fraught with peril. In both the short term and the long term, it requires bold bets on disparate items, from commuting habits to government interventions in a wide variety of spheres, to private sector capital allocation.

The price of oil in the future will be led by many of the same considerations that dictate the current oil price listed above. These most important factors, which are far from discrete, include:

  • global demand. Statements such as “oil demand has already peaked in rich countries” are so prevalent that they verge on becoming truisms. It may have peaked worldwide already. Or not. You do not have to be a Tesla-bull to anticipate a great surge in the adoption of electric vehicles, nor do you have to be a terrible cynic to imagine that the internal combustion engine will still be with us in 2030;
  • government regulation. In the past politicians have served as cheerleaders for oil. Its sale creates revenues without taxing the citizenry. It seems highly unlikely that this will continue, given concerns over climate change, although President Obrador of Mexico is a notable exception to this trend. Government intervention can and will affect both the supply and demand of oil in the future, no matter what form of carbon tax is adopted or nomenclature is assigned to it;
  • the willingness of investors to associate themselves with oil, let alone bet heavily on its prospects. Anyone doubting the vitriol aimed at investors and banks associated with the energy sector should research the 2020 JP Morgan annual general meeting for salutary lessons. Oil company valuations have sagged for years and energy has been the worst-performing sector in many indices for most of the past decade. Strenuous efforts to protect dividends (eg, through the cuts to capital spending) have been greatly undermined by the current crisis (see Royal Dutch Shell’s decision to slash its dividend by two-thirds). While investment committees are hesitant to ignore oil stocks in case it prevents them from reaching their financial targets, there is a body of evidence to suggest that omitting the stocks of any sector of an index over the long term has a minimal effect on total returns. This may currently seem surprising: few investors would take solace of this farsighted view had they, for example, ignored US technology companies in recent years;
  • the attractiveness of renewable projects. If the return on a new windfarm can rival or outperform the return on a new oilfield, investors and energy companies will take note; and
  • the activities of oil companies themselves. Aside from the burden of regulation and litigation, reparations for harm previously caused may afflict the industry, as the tobacco industry discovered in previous decades. Oil companies were already scything their capital spending, even before the present precipitous price drops. On a separate note, some major oil companies, notably BP, have promised to reduce greatly the net carbon footprint of everything they produce by 2050. The oil industry has the balance sheets and the experience of managing projects to dominate the move away from oil, ironic as that may sound. As hinted at above, there is reason to believe that the oil industry could emulate the behaviour of many utility companies in the 2010s, increasing shareholder returns while producing cleaner energy. Iberdrola in Spain, Enel in Italy, and E.ON in Germany are exemplars of this trend.

Should consumers, investors, governments and – perhaps most crucially – oil producers turn against oil in the coming years, then oil prices may well continue to languish before fading into irrelevance. The prerequisite for this shift is not changing sentiment; it is the prevalence of viable alternatives. Whether you think they are likely to emerge and succeed is a matter of personal judgment.

Patrick Thompson is a trainee solicitor at White & Case.