A chance for global economies to reorient themselves

This article appeared originally in Gulf News: link to original article

‘Norway’s assessment of its shale gas potential went from 83 trillion cubic feet (tcf) (2011) to zero (2013)’.

This was noted by the US Energy Information Administration (EIA) and quoted in an op-ed that appeared on World Economic Forum website. A study by the University of Texas predicted the ‘US boom will tail-off by 2020 and not keep going to 2040 as previous less-thorough analysis have predicted’.

In a policy briefing by the policy department in the European Parliament (2013), estimates of ‘US shale gas reserves of recoverable natural gas’ dropped by 42 per cent from 2011 projections.AdTech Ad

Why is this relevant? And why are figures of shale gas reserves being quoted here rather than those of oil which is of a concern today? According to the same policy briefing, “From 2005 the [US] dependence on oil import has dropped from 69 per cent to 39 per cent, thanks to shale gas’.

So that, and the constant increase in US oil production, contributed to a drop in oil prices to a five-year low of below $60 (Dh220) a barrel and further decreasing dependence of the US economy on energy imports. All of that was made possible by close to zero per cent interest rates, negative rate for cash in banks and substantial loans for the sake of investments.

The above is to understand a couple of dynamics in the oil markets which were affected in part by a huge surge in supply of oil. In such a case, demand doesn’t need to weaken, neither does it need to slow down. It’s enough for demand to stay on status quo and for all of the abundance in oil to exert constant downward pressure on prices.

The drop is a clear sign of a trend that is not about to fade out any time soon. The first part of this report, published earlier in Gulf News, pointed out which countries can survive the current trough where no bottom has been reached as yet. Reference was also made to the different tactics the countries could employ so as to serve their best interests, including raising interest rates to encourage capital flows into the economy, or depreciating the currency to encourage exports.

Both tactics aim at boosting foreign currency reserves. Speaking of which, and probably the most powerful factor in the case of a drop in oil prices, is how much cash reserves a country holds. These were discussed more thoroughly in the previous report.

The second part deals with companies, or producers, investing in the shale industry, which according to an Economist op-ed amounted to ‘20 per cent of global investment in oil production last year’. The argument extends to how vulnerable they are to the current debacle in oil prices.

Debacle here depends on where one stands. Anyway, the argument states that companies are affected based on how much debt they hold in their financial statements. In terms of cost of extraction, a few reports have stated that many companies extracting oil in the US can be profitable as long as prices do not drop below $40 per barrel.

This means that in terms of carrying on existing operations, companies with low operational costs and less debt on their books can withstand the downfall. However, smaller companies which borrowed heavily to fund exploration and extraction projects will be the most affected.

‘Total debt for listed American exploration and production firms has almost doubled since 2009 to $260 billion’, according to Bloomberg. The same report states that ‘investment would drop by 50 per cent’. Alan Krupnick, a scholar at Resources for the Future think tank, suggested in a post there might be a future trend of mergers among smaller companies if they are to survive the current downward spiral in oil prices.

The third part of the report is to discuss who is benefiting from the decline. A rule of thumb, that was established in my earlier report too, was that a net exporter of oil would be hurt while a new importer would benefit.

The degree of the effect is subject to the budgeting price per barrel. For instance, Djibouti, Seychelles, and Kyrgyzstan are gaining up to 11 per cent worth of their GDP (Wall Street Journal). The gain is basically reflected in a higher household income realised by individuals as they spend less on fuel.

Even here, the effect is subject to how much fuel each household consumes. Higher the share of disposable income is expected to counter balance a possible drop in inflation rates because of the drop in prices, portrayed by higher consumption by individuals.

Back to the US and the intention of the Federal Reserve to raise interest rates. This may in fact cause a double deflationary effect to an economy where an inflation target of 2 per cent is yet to be achieved.

Japan, however, might be better positioned to benefit from the drop in oil prices if prices weren’t locked up in contracts. That is because of Japan being a net importer of oil, and because it has been battling deflation seemingly forever. With the second hike in consumption tax being delayed, the scenario would be ideal.

The fourth and final part here sheds light on consumers as well, but from a government perspective. The projection is that if the current drop in oil prices is maintained, it would pass $1.2 trillion from producers to consumers. But that doesn’t need to be the case.

Governments who introduced subsidies, whether on fuel or something else, face a tough decision trying to reduce the subsidy percentage or even foregoing it altogether. In many instances, subsidies are a contributor to inflated government spending, as they also promote excessive usage since a great share of the subsidy benefits producers rather than consumers.

With the current drop in oil prices, a gradual removal of subsidy might be feasible if carefully done in accordance with the downward trend. This would be of major significance for countries for whom the drop in oil prices have affected negatively.

The countries and subsidy percentages of their GDPs are as follows (based on 2012 estimates): Iraq (14.3 per cent), Saudi Arabia (13.3 per cent), Bahrain (10 per cent), Ecuador (9.7 per cent), Libya (8.8 per cent), Venezuela (8.1 per cent) and Nigeria (3.6 per cent).

In total, governments ‘pay $480 billion a year for subsidies, or 0.7 per cent of global GDP’ (IMF). In addition, the IMF estimated government support for fuel subsidies to accumulate to $1.9 trillion in 2011, including here ‘damage done by subsidised fuel to public health, the environment, and infrastructure’ according to Bloomberg.

In conclusion, effects of the current downfall is positive for net importers of oil as long as a government manages to transfer the money saved to growth-generating factors for the GDP, increased consumption being an example. As for net oil exporting countries, now is a good time to consider winding off subsidies which would partially fill the gap in government budgets caused by the drop in oil prices.

Also, and if no interest rate hikes were perpetuated, aiming for higher inflation target would aid in depreciating the currency and promote exports other than oil. This is subject to what the percentage of oil exports is of the total.

Currencies pegged to the dollar may not enjoy similar maneuvering space in monetary policy, though they enjoy higher purchasing power versus currencies that have been depreciating against the dollar such as the yen and the rouble.

For producers in the shale business, their future is not only subject to what floor oil prices will drop to or the amount of debt they obtained to finance operations, but also to a drop in their publicly traded stocks as investors either refrain from further investments or dump current holdings. If they survive all of that, prospects of them getting into additional shale projects will be minimal.

Demand will eventually catch up with supply and balance the market, never at the previous peak prices though, hopefully with fuel subsidies being greatly reduced or eliminated altogether. The last thought I want to leave you with is: Will there ever be another shale boom?

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