HOW do you explain the current nervous breakdown in the global oil market? Begin by asking a simple question: why should there be a “correct” single price for a barrel of oil?
After all, petroleum comes in every consistency between tar and the amber liquid you put into your petrol tank. Then there is the added factor it might come from seven miles under the ground, with a stormy ocean in between, or just pop out of the desert sand. None of this makes for uniform pricing.
Fortunately for oil traders, there is a simple solution. The defining characteristic of oil is that it is a finite resource – God simply isn’t making any more. Which implies that the true value of a barrel consumed is what it costs to find its replacement. The price of oil is not its production outlay – which varies enormously – but the cost of finding the next barrel.
Because we have already extracted all the easy-to-get petroleum, the market price of oil has risen to above $80 in recent times. This reflects the minimum companies are having to shell out to find and extract new supplies. Indeed, the market had started to feel happy with $100 plus, reflecting the massive amounts of cash the big oil majors have had to borrow to develop new oil fields, mostly in politically unstable places.
Of course, short-term supply and demand factors can upset the applecart. If a war interrupts supply to the petrol pumps, oil prices can spike. Equally, a warm winter can produce a temporary excess that sees the price fall. Commodity speculators also cause aberrations – as they did just before the credit crunch in 2008. But otherwise, the “floor” price of a barrel of oil reflects its known replacement outlay.
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Six months ago, the bottom suddenly fell out of the market. Yesterday the price of North Sea crude neared $50, while the US benchmark went to $48, spooking global equity markets. And spooked they should be. If the market price deviates from the replacement price for too long, large sections of this heavily indebted industry will implode, taking the Stock Exchange with it – a quarter of the FTSE is composed of oil and mining companies.
Which means George Osborne and Ed Balls will have to tear up their deficit reduction plans. While most oil producing countries save for a rainy day, the UK Treasury is unique in spending all its petroleum income, leaving Britain’s budget vulnerable to precisely the market meltdown that has just occurred. After that, how long before foreign investors decide that funding the UK’s gargantuan current account deficit (a jaw-dropping 6 per cent of GDP) is a risk too far? Unless, of course, the Treasury hikes interest rates. Such an outcome would be hubris after the glee with which Labour and Conservative politicians have used the oil price drop to beat the SNP.
Will the global oil market recover its senses? The proximate cause of the price downturn was a modest over-supply in world production, caused largely by a slowdown in Chinese oil imports and the surge in US shale oil production. Most analysts assumed this imbalance was temporary.
True, many forecasters were predicting that burgeoning US supplies would force the basic world price to $80 on a semi-permanent basis. But such a price would still be within the range for supporting further oil exploration. Talk of $80 allowed No campaigners in the Scottish referendum to criticise SNP budget forecasts for after independence.
But these scenarios have not transpired. Why? Because the oil market is so uniquely political that trying to engineer a new price “floor” usually ends in tears – for the simple reason the players can never agree what it should be till after a lot of blood-letting.
When the temporary over-supply in the summer started the price slide, everyone expected the Saudis to cut production when the market reached circa $80, thereby ending the glut. The Saudis are the cheapest producer so can always make money at lower prices. Since the Second World War they have acted as swing producer – vital for global economic stability – in return for Washington’s military guarantee. Unfortunately the Saudis no longer want to play ball and that is the cause of the crisis. Be frightened.
The Saudis feel betrayed by the Americans. They see the US shale industry as a competitor and America’s way of escaping dependence on the Saudi regime – both of which are true. But without US protection, the regime in Riyadh is doomed. The ruling Sunni dynasty, headed by ailing 90-year-old King Abdullah, is threatened by a Shiite rebellion in Yemen and the enmity of Islamic State across the border in Iraq.
To get the attention of the White House, the Saudis have deliberately forced the price of oil below the cost floor needed by US shale oil producers. This international game of chicken could last a while longer. High cost US shale producers have insured themselves against a fall in the global price of oil – so-called hedging. Paradoxically, this means they have made a profit on the oil drop. But reinsuring will cost them a small fortune, after this year. The Saudis seem determined to keep pumping till then.
Oil prices will rebound to the petroleum replacement floor – they always do. I’d still bet on $100 plus. That means we need to plan for the future of the North Sea sector, always vulnerable to price fluctuations because of its high production costs. In a world where oil is a political commodity, nurturing your own industry should be common sense.
Except in the UK, of course, where George Osborne hopes cheap oil will fool voters into feeling better off. And where Jim Murphy thinks you can fund the Scottish NHS by taxing Russian oligarchs living in London rather than by rebuilding the Scottish economy. The latter surely involves giving Holyrood control over the North Sea oil industry, where it will be nurtured rather than used as a cash cow by the UK Treasury.
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