We received this note recently from the Premier Miton fund managers. It's a good summary of the recent moves in the price of oil and what that means for the longer term. It's particularly useful for those looking to dip a toe into beaten up oil funds or countries that are heavily reliant on the price of oil.
(Premier Miton)
Implications of a lower oil price
Just over twenty years ago, oil was priced at below $20 a barrel for an extended period. The argument at the time was that the world had plentiful supplies of cheap oil underground and that production costs were falling over time. Over the last twenty years, we have seen prices as high as $140 while those conditions still persisted. Following a recent price collapse, we are back again at $20.
The reason of course is the operation of a cartel. OPEC plus Russia, which represents most of the world’s low cost oil production, has managed to constrain supply. This is in members’ interests to the degree that higher prices offset lower output. Sustained high prices have, unfortunately, led to two less desirable consequences for the cartel. The development of non-traditional fossil fuels, such as shale oil and gas, and renewable energy. In both cases, high oil prices provided head room for the development of these resources, while technology advancements enabled production costs to fall rapidly towards the costs of more traditional oil reserves.
The consequence of this has been a gradual erosion of the market share of cartel members, and more recently, a loss of market share to renewables in key areas. Ultimately, this begins to call into question whether the strategy is working, as the trade-off between prices and volumes starts to work against the cartel members. Problematically however, many cartel members have used the excess income from high prices to build not just superyachts and palaces, but also massive domestic government budgets. This means that gulf states, in particular, are unable to sustain low oil prices for an extended period of time without a major disruption to their finances and economies, risking social disorder.
Commentators initially thought the price war was an attempt to drive the higher cost producers out of the market, perhaps permanently, in order to re-establish the old order. Perhaps this is so, and there is evident distress amongst the more poorly financed US shale producers. However, all in shale costs are still well below the level of the oil price required to sustain Saudi Arabia’s and others’ government budgets, so if that was the strategy, it won’t work. More plausibly, we are simply seeing the consequences of an oversupplied market with falling demand, the cartel could work when there was enough demand, but now the dynamics are different. If oil demand in the long term is declining in favour of renewables, is it better to sell your oil at $20 or leave it in the ground at $60?
The longer-term consequences of a sustained lower oil price are potentially very positive. Cheap and abundant energy is the lifeblood of a vibrant economy. The combination of ever cheaper renewables and an abundance of cheap oil is highly positive for productivity and growth in the longer term. Particularly where oil is lowly taxed, such as in the US, the impact of a low oil price on consumers’ disposable incomes (once economies reopen), is very significant. For businesses too, a major input is now much cheaper, supporting profit margins.
In conclusion, in the short term if these low oil prices persist, there will obviously be distress and defaults for many of the overleveraged higher cost oil producers, but markets have arguably priced this in. There is also a medium-term risk of political instability, not just in the Gulf states but also West Africa and Latin America, where oil production has supported otherwise weak economic and political systems.
Longer term however, the impact of cheap energy is unambiguously good for economic growth and disposable incomes in the energy consuming nations. While we may not be seeing negative oil prices again for some time the structural oversupply of oil and the ever-falling cost of renewables makes a strong argument that energy costs will remain lower for longer.
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