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The brave new world of cheap oil

The brave new world of cheap oil

The price of oil has fallen from $115 to below $45 a barrel in just seven months, with profound implications for all of us



Why is the oil price plunging?

There are several plausible reasons. Top of the list is the most obvious: supply and demand. For the time being at least, the world has too much oil on its hands. The Chinese economy has been slowing for the best part of a year, while most of Europe is yet to rebound from the economic crisis. This has reduced global demand for oil at the precise moment that new supplies – chiefly in the form of fracked oil from the US – have come on stream. Other factors are important, too: against the odds, Iraq and Libya – despite serious security problems – have kept up their oil production, and the oil cartel, Opec, led by Saudi Arabia, has defied expectation by deciding not to turn off the taps. Nonetheless, the speed and extent of the oil price drop – it shows no sign of levelling off – have come as a huge surprise.

Why has it caught experts by surprise?

Because expensive fossil fuels had become a fact of life. "Hundred-dollar oil is here to stay," wrote Professor James Hamilton, a respected oil economist at the University of California as recently as last July. Despite being one of the most volatile commodities since the mid-19th century – the cost of a barrel of oil has fluctuated between $10 and $120 (adjusted for inflation) since then – the price of oil had remained stable for the last four years or so. Logic dictated that on a crowded planet where cheap supplies had already been exploited, and the demand for energy was only going to increase, the price of oil was only going to go up. Even as it began to fall, last October, the IMF warned of a 20% rise in oil prices in 2015, because of instability in the Middle East.

Why were the predictions so wrong?

In the past, economists have tended to see the oil price as something of an oddity, responding more to the interplay of politics, rather than the purely market forces of supply and demand. In part that is because oil is so essential to our lives, so demand for it tends not to vary much with price: people and businesses go on paying their energy bills and filling up their cars regardless. Supply is pretty "inelastic", too: new oil supplies only tend to come on line after years or even decades of engineering development. Then there is geography. Since the 1930s, most of the world’s oil has come from the Middle East: the Arab nations of Opec have historically been able to respond to any political upheaval by adjusting the amount produced, thereby setting prices more or less where they wanted them. So the oil price has been more a function of the revolutions, conflicts and embargoes affecting the Middle East than almost anything else.

And is that now changing?

Yes, because the fracking revolution has transformed the dynamics of the global oil market. It has meant the US now produces nine million barrels of oil a day, only just behind the Saudis’ ten million. Opec’s share of world production has shrunk to 33%, down from 53% in the 1970s. When prices fell last November, the cartel decided not to curb supply, as it almost certainly would have done in the past.

Why didn’t it do it this time?

Some say it’s because Opec isn’t as strong as it used to be; its members are divided. (In cash-strapped Venezuela, for example, oil represents more than 96% of exports, so it can’t afford to stop pumping.) Another theory, however, is that Gulf oil producers want to keep prices low in order to undermine their newly emerging rivals: "Sheikhs vs Shale" is how The Economist describes the politics behind the oil-price fall. Traditional producers like Saudi Arabia, with $900bn in cash reserves, can sustain a falling price far better than their fracking counterparts. Saudi Arabia extracts oil at a cost of around $6 per barrel; for most US fracking projects the cost is closer to $65. "A period of cheaper oil could drive high-cost operators to the wall... and let the Saudis regain market share," says The Economist.

Isn’t that good news for the world economy?

Owing to one of the main reasons the oil price is falling in the first place: diminished economic activity, notably in Europe. "There are plenty of situations where falling oil prices are just symptoms of a wider malaise," says Stephen King, group chief economist at HSBC: if so, low prices won’t be the magic ingredient that gets people spending again. In fact, with inflation and interest rates already at record lows in Europe and the oil price continuing to fall, some analysts predict the continent is likely to dip into deflation this year, an outcome governments dread, as falling prices tend to inhibit investment and lead to falling wages.

Who will be the big loser?

The global oil industry. About $1trn of planned oil projects, says Goldman Sachs, are now at risk of cancellation – especially those in such inaccessible places as the Arctic, where Exxon-Mobil and the Russian firm Rosneft recently spent $700m drilling a single oil well. In the unpredictable world of cheap oil, such schemes are no longer viable. But optimists hope there will be big winners too, and not just the Western motorist. The West as a whole could gain politically, as falling revenues put huge pressure on Russia, Iran, Venezuela and other outcast, oil-producing nations to seek better relations with Europe and the US. Above all, however (see box), it’s the world’s farmers who’ll be celebrating.

Farmers of the world, rejoice!

More than anyone else, it is the men and women working on the world’s 570 million farms – mostly in poor, developing nations – who are feeling the impact of falling energy prices. With its reliance on fertilisers, transport and water pumps, global agriculture is between four and five times more energy-intensive than manufacturing, according to the World Bank. In India, the government spent a massive $22bn in fuel subsidies in the year to March 2014, to support hundreds of millions of people living in rural poverty.

The fall in the oil price since last summer has allowed Indian Prime Minister Narendra Modi to do something India’s elected politicians have never been able to do before: cut the vast diesel subsidy. In Indonesia (as in other emerging economies), the cost of fuel subsidies is even higher – some 20% of the national budget. The International Energy Agency calculates that the falling oil price will allow around $150bn in fuel subsidies around the world to be cut this year, enabling governments to reform their economies and invest elsewhere.

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