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McKinsey cheat sheet on low oil prices

Hydrocarbon Engineering,

Over the past seven months, the price of a barrel of oil dropped from US$107 to less than US$50. This took prices to 2009 levels and caused many global indexes to fall. McKinsey & Company considers the implications:

The good news

For US consumers, the drop in oil prices is excellent. A two car family that drives 2000 miles/month might have to buy 100 gal. of gas. With the average price/gal. now US$1.25 less than it was at its 2014 peak, that adds up, essentially to a US$125/month raise. For American households, spending on gas is on track to be the lowest since 2003, McKinsey highlights.

European and Japanese consumers, who drive much less and for whom taxes account for a much higher share of their price at the pump, will not benefit as much. Still, since both markets are importers, less expensive oil is a nice little economic boost. On the other hand, it also adds to the deflationary pressures that are hampering these markets’ ability to retire debt. Still, on the whole, a net benefit.

Countries that subsidise the price of oil, such as India, will also benefit (though they really should seize the opportunity to cut such subsidies on the way to eliminating them altogether). Analysts reckon that every US$20/bbl fall in the price raises global GDP growth by 0.4%.

The bad news

Crashing oil prices are bad for oil companies; the S&P energy index fell more than 19% in the second half of 2014, and high cost producers may have to shut down some operations. The Financial Times has estimated that some US$1 trillion in planned production projects are in danger of cancellation.

However, McKinsey highlights the really crushing and scary situation as being to do with state owned producers. The simple fact is that many of the places that rely most heavily on fossil fuels are not exactly easy. Plunging prices poke holes in state budgets and can have wider ripple effects. McKinsey urges us to consider:

  • Nigeria. The currency, the naira is at its lowest level against the dollar since at least 1999.
  • Russia. The ruble is haemorrhaging, which is hardly surprising, since oil and gas account for three quarters of the country’s exports. The weaker ruble will drive up the price of food; in addition, international banks hold a fortune in Russian debt. If that debt cannot be serviced, the still fragile global financial system would get seriously hurt.
  • Venezuela. This place is already in such a mess that it had shortages of toilet paper. Debt default is a real possibility.
  • Iraq, Iran and Libya. These countries rely almost entirely on oil for their export earnings and domestic budgets. In a region that is hardly short of turmoil, more of it isn’t out of the question.
  • Norway. Even Norway is warning of a ‘severe downturn’.

Don’t get used to it

Some analysts say that prices will rebound in six months. Others think that they will stay low for two years or more. Some believe that prices will eventually come back to US$100/bbl. Others say they will come back to a new equilibrium, perhaps US$80. Scott Nyquist, Director in McKinsey’s Houston office, admits he doesn’t know what will happen in this regard. However, US$60/bbl is not sustainable.

Already, energy companies are cutting upstream investment. Also, at less than US$60/bbl, a lot of higher cost production is no longer economical; that includes a good deal of US shale. Both factors will reduce the amount of oil that reaches the market and will eventually drive prices up.

After all, Saudi Arabia has indicated that its priority is to protect OPEC’s market share; therefore, the cartel has agreed to cut production, at least for now. If Saudi Arabia decides to get more aggressive and produce more, that would obviously depress prices. But OPEC suffers with very low oil prices. On the whole, then, the long term pressures are in the other direction.

No more peak oil?

According to McKinsey, peak oil is one of those fashionable notions that simply cannot be killed, no matter how often reality contradicts it. It is the idea that oil production has maxed out and that decline is therefore inexorable and inevitable. In the original declaration of peak oil, the US was supposed to run out of oil some time in the 1960s, and the date keeps getting pushed back. There was a peak and a decline, but in the past few years, thanks mostly to the exploitation of shale resources, there has also been a recovery. Under peak oil theory, that cannot happen. But it has.

A better play than peak oil is to bet on the power of the market and the human ingenuity that propels it. High oil prices encouraged substitution on the demand side, in the form of greater efficiency and other measures. They also encouraged innovation: finding new sources of supply, such as oilsands in Canada and shale in the US. Basically, when oil prices went up, so did the interest in alternatives and their economic viability. There is no reason on Earth to expect that dynamic ever to change, McKinsey concludes.

Adapted from a press release by Emma McAleavey.

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