NS4054 Fall Term 2015

Discussion Articles Week #3

Promise and Peril of Cheap Oil I

• Jason Bordoff, “The Promise and Peril of Cheap Oil, Foreign Policy, October 9, 2015

• Question – does cheap oil help or hurt U.S. energy security? Over what time period?

• Focuses on the unintended consequences of cheap oil• First, cheaper oil can

• Can stimulate people to drive more and encourage more overall use.

• Act as a tax cut for consumers. Gas savings amount to nearly $100 per month per household

• Stimulate the economy. Recent analysis finds must are spending their windfalls rather than saving

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Promise and Peril of Cheap Oil II

• Second, low prices and falling U.S. output risk undermining momentum toward instituting smart policy responses to the shale revolution.

• U.S. output from shale will rise again as prices recover

• The last year has forced the industry to make dramatic improvements in the economics of shale production

• State and federal regulation must continue ensuring that production happens safely.

• Tighter margins and lower profits seem to be leading businesses to fight especially vigorously against even low cost and smart regulations

• Such as the administration’s efforts to reduce methane emissions from oil and gas production.

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Promise and Peril of Cheap Oil IV

• Third, while U.S. economy benefits form lower oil prices, it benefits less than in the past.

• While consumers on the whole better off, oil and gas producing states will see net employment declines -- especially Wyoming, Oklahoma and North Dakota

• The overall impact on the U.S. macro economy of an oil price rise or fall also declines as the U.S. import dependence declines –when prices rise more of the increase in oil producer revenue stays within the U.S.

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Promise and Peril of Cheap Oil V

• Fourth while oil prices are low today they are likely to be more volatile in the future due to important changes in the oil market

• OPEC for the time being has given up its role of market balancer, leaving very little buffer of spare capacity

• OPEC’s spare capacity today is less than 1.3 million b/d, the lowest level since 2008

• Without that buffer, any disruption to global supply could have a magnified impact on price

• Potentially U.S. shale oil production can now contribute to the swing supplier role as it can be ramped up and down more quickly than conventional oil

• However if prices fall low enough and long enough to pull U.S. shale off the market and then rise high enough to prod it back, may have even greater price swings.

• Highly volatile prices harms the economy stymieing consumption and investment 5

Promise and Peril of Cheap Oil VI

• Fifth, lower prices create an increased risk of political and economic chaos in oil-producing countries.

• World Bank estimates that a 10% decline in oil prices can cause economies to contract 0.8 to 2.5%.

• Saudi Arabia, oil exports account for almost 90% of budget revenues and 43% of GDP

• In Iraq the numbers are roughly 80% and 45% respectively

• While countries like Algeria, Nigeria, Russia, Venezuela and Iran are similarly dependent on oil

• Several of these countries like Saudi Arabia have reserves to fall back on – others do not.

• Increased instability in producer countries can have significant ripple effects globally

• From reduced revenue for battle against the Islamic State to stability of Caribbean and Latin American countries that have long depended on Venezuelan oil discounts 6

Saudi Arabia/Iran I

• Nick Butler, Oil and the Tinder Box of Iran-Saudi Rivalry, Financial Times, October 5, 2015

• While Saudi Arabia and Iran have been conducting proxy wars for years, now a growing risk of open war between the two countries.

• If the case oil facilities and exports would be primary targets – price spike likely

• Asks whether such an escalation can be prevented

• Conflict between the two countries has many dimensions

• Religious

• Economic

• Territorial

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Saudi Arabia/Iran II

• Three factors combined to create this dangerous situation

• First. Iran nuclear agreement has opened an opportunity for Iran to build and strengthen its network of links across the region

• Second. Russian intervention in Syria demonstrates the indecisiveness of US led coalition against the Islamic state

• Third – partly as a consequence of first two, Saudis under a new king have decided that they have to protect their own interest. Feel U.S. ignored their concerns in the Iran nuclear deal

• Saudi policy of assertiveness includes direct action in Yemen and extends to the continuing attempt to take control of the oil market to protect their market share

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Saudi Arabia/Iran III

• Oil would be a primary target if the situation deteriorated

• The facilities and tankers though which Saudi Arabia exports almost 7m barrels a day are vulnerable

• So is on shore production in an area with a substantial Shia community

• The Aramco’s electronic control systems have been hacked before and would be targeted again

• An open war not inevitable – but likely any solution will have to come from within region – between the Saudis and Iranians themselves

• Rationally there should be no war – no guarantee that rationality will prevail.

• Most oil now flows east rather than west. Does this mean U.S. unaffected? 9

Saudi Arabia and Oil Prices I

• Nick Butler, Oil Prices – The Saudi Dilemma, Financial Times, August 17, 2015

• Age old problem of trying to anticipate what Saudi Arabia will do on a number of fronts

• Hard to get a sense of changing energy security without this type of analysis

• Fact:• Oil production capacity continues to increase despite the sharp

fall in oil prices• Did the Saudi strategy of overproduction designed to force other

producers out of the market fail?

• Will the Saudis continue their strategy? or

• Change course with loss of face?

• Outcome will shape the future of the region and the international oil market

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Saudi Arabia and Oil Prices II

• Saudi troubles

• U.S. deal with Iran transforming regional power

• In a year Iran may be exporting an additional million barrels a day in an already weak market

• Saudi campaign in Yemen to counter Iranian influence has not gone well

• Low oil prices have backfired – U.S. shale producers increased efficiency with production in 2015 likely higher than 2014

• What’s next?• Assertive approach

• Oil market, Saudis may feel need to go to $40 a barrel to slow shale development – could hold at this level for several years

• May explain stepped up borrowing to preserve FX reserves

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Saudi Arabia and Oil Prices III

• Pragmatic approach

• Why risk conflict in region or with other oil producers?

• Best to ensure survival in power

• Survival probably requires an extended period of calm and some evidence of an improving economy for ordinary citizens

• Internal the economy needs reforms such a removal of inefficient subsidies

• Gas costs 16 cents a liter and costs government $80 billion a year in foregone export revenue

• Much oil used to keep air conditioning going – need to shift to natural gas

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Saudi Arabia and Oil Prices IV

• Need to stabilize price at higher level

• Saudis are finding they not the power they would like to be in oil market

• Older Saudi decision makers may be out of touch with today’s oil markets

• Pragmatically Saudis should accept price in $70 to $80 range for next five years

• Will need to cut production along with Kuwait and the UAE

• Production may have to be cut by 2m barrels a day especially if Iran and Iraq step up production

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Saudi Arabia and Oil Prices V

• Similar pragmatism needed in other areas.• Although rivalry with Iran – scope for cooperation against Isis• To be a cause of further instability by pushing prices down

can only foster hostility and add to the dislocation on which Isis thrives.

• Internationally as well as well as regionally Saudi Arabia needs friends

• 1000 lashes to a blogger and 102 beheading so far in 2015 not the way to do this

• Concludes thinks a change in policy more likely than not

• Over years caution rather than assertion ha served the kingdom pretty well

• Change in policy would probably mean a change of leadership and a departure of the deputy crown prince

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Russia and Falling Oil Prices I

• Nick Butler, Russia in Trouble as Energy Prices Fall,” Financial Times. August 21, 2015

Facts:• Energy is the largest single sector of Russian economy – one

quarter of total GDP, down form a third two years ago• Energy exports account for about 68 percent of Russian trade• Oil and gas revenues provide half the Russian government’s

official budget and uncounted but substantial amount of the unofficial funding that supports the country’s power structure

• As a result of the fall in oil prices Russian economy is predicted to decline by 3.5% this year with oil export revenue down by $95 billion

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Russia and Falling Oil Prices II

• Immediate problem not sanctions imposed by the West• The issue is economic• Most of Putin’s 15 year reign has coincided with strong energy

prices and growing production of oil and gas• Resulting revenue ha enabled Kremlin to keep most people happy

• Businessmen, the military, the middle class of Moscow and St Petersburg, and most of wider population

• However, little done to prepare for the current downturn

• Economy has not been diversified

• A reserve fund but amounts small and will soon be drained if low oil prices continue

• Very limited improvement in infrastructure, particularly in the energy sector

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Russia and Falling Oil Prices III

• Gazprom is set to produce less gas this year than at any time since fall of the Soviet Union

• Market share expected to drop by 30% this year

• Gas-to-gas competition

• Fed by increased flows of LNG has broken the traditional link between gas and oil prices,

• Is changing the structure of he market the Russians had taken for granted

• In addition Gazprom’s trading activities under attack from regulators in Brussels

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Russia and Falling Oil Prices IV

• Situation in oil no better.

• Russia exports 6m b/d – each worth 40% less than two years ago

• Large surplus of supply over demand

• Good reason situation will continue for several years and oil prices languish

• Sanctions and associated isolation of Russia because of Ukraine not immediate cause of problems, but they compound the country’s long term difficulties

• Russia needs to expand oil production into new areas but international oil companies in not hurry to invest with sanctions in place

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Russia and Falling Oil Prices V

• Fears about Russian economy resulting in massive outflow of capital

• Exodus of capital since Ukraine crisis could reach $300 billion by end of 2015

• Situation dangerous because options for Russian government are so limited

• Oil and gas markets being shaped by forces Putin can not control

• Downward cycle could take years to play out

• Even a resolution of Ukraine crisis would not restore Gazprom’s market share in western Europe

• Deals to sell gas from east Siberia to China and others make sense but will not make money for another decade

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Russia and Falling Oil Prices VI

• Real risk is that economic discontent will force either existing Russian government or its replacement into harder political stance

• In many ways last 25 years of relatively stability are not the norm

• One of the major reasons for fall of the soviet Union at the end of the 1980s was the collapse in energy prices

• Russia is weaker now that at that time.

• What are the implications for U.S. energy security?

• What would we need to know to make an assessment?

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