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01 October 2023

Why oil prices shouldn't decline further

By Pradeep Unni

Amidst the burgeoning credit crisis and its ripple effects in allied sectors of the economy, a sharp slide in oil prices was a great blessing in disguise.

Imagine soaring inflation amidst an economic recession and job losses. However, any deeper slide in oil prices may have long-term repercussions on the global fuel economy as a whole.

At the first glance repeated efforts by the Organisation of the Petroleum Exporting Countries (Opec) to stabilise the prices by bringing in deep production cuts may look like a profit motive move of the group. But in actuality, such efforts have long-term positive impact and Opec has been echoing this in its every meet.

Since the prices started to fall from the peaks of $147 a barrel, Opec has cut output three times in an effort to remove about five per cent of world supply to halt the slump in prices.

The latest to announce production cuts was the UAE. Abu Dhabi National Oil Company (Adnoc), the main producer in the UAE, the world's fifth-largest oil exporter, said it would cut February supplies of Murban and Upper Zakum (crude oil grades) by 15 per cent and Lower Zakum and Umm Shaif by 10 per cent each. The allocations follow a decision by Opec to reduce supplies by 2.2 million barrels per day from January 1, 2009. Top exporter Saudi Arabia had informed its customers of cuts even before the meeting on December 17, 2008.

What many refuse to see is that sustained decline in oil price also has long-term negative impacts. Lower oil prices reduce the will to move ahead with renewable energy projects like bio-fuels, solar, wind and nuclear energy. Lower oil prices turn such alternative sources of energy economically unfeasible to promote and subsidy, if given, might become too costly. Many non-traditional oil sources like oil tar sands of Canada, Alaskan oil wells and other offshore wells might become uneconomical to be approached.

Economists forecast that almost 800,000 to one million barrels per day of Canadian oil might go off line if oil prices dip below $38/barrel. Below $30, most traditional oil fields might turn unfeasible at the current costs and at $20-$21 a barrel, almost every oil well, including those in Middle East, might turn unprofitable. Reports from the International Monetary Fund (IMF) reveal that the breakeven oil price for 2008 fiscal account (ie, the price at which a country would achieve a fiscal balance) is $23 a barrel for the UAE. This is the lowest in the GCC and much lower than the average of $57. This demonstrates that most oil exporters, including the UAE, can easily absorb lower world oil prices, but at the cost of other developments. These calculations are entirely based on average cost of operations and might vary from firm to firm and also might totally change in different time frames.

Lack of investment might also result in many oil-exploring companies going bust, along with job losses and reduction in skilled work force. This impact could be same as the decline in gold prices after its first historic rise to $850 in early 1980s. The subsequent deep slide in gold prices slowed exploration and mining attempts, resulting in diffusion of skilled work force to other sectors. When the economy returns to normalcy, supply sources become less or the quantum of production becomes less to meet the surge in demand and this triggers a rally in oil, crippling steady economic growth.

The swift and sharp slide in oil prices has also forced many large consumers to delay their long-term purchase commitments as there are ample stocks available in the immediate term for consumption. This has further derailed the necessity for continuously generating fresh production and also slowed the process of finding new oil sources. US commercial crude oil inventories (excluding those in the Strategic Petroleum Reserve) now stands at 318.2 million barrels, which are still in the upper half of the average range for this time of year. Crude inventories at Cushing, Oklahoma, the delivery point for crude futures contracts traded on the New York Mercantile Exchange, reached 28.7 million barrels in the week ended December 19. It was the highest since at least April 2004, when the government started collecting Cushing data. It is because of this reason Opec believes that forward demand cover for oil should be lowered from 56 days to 52 days, the average over the past five years.

Coming to more regional aspects, the entire economic growth and diversification to non-oil revenues in the Middle East region may slow if oil extends its decline continuously. Reports reveal that the real economic growth in Saudi Arabia, the UAE and Kuwait may slow below three per cent next year as the global recession and tight credit markets hurt activity in the region. The combined size of Gulf economies might slump from $1.05 trillion (Dh3.8trn) this year to $934.5bn next year. Economist Intelligent Unit (EIU) forecasts the growth in the Middle East and North Africa region to slow down to 4.6 per cent from the projected 6.1 per cent rate for 2008.

It is under these contexts that Saudi Arabia, the world's largest oil exporter along with other producing nations, has been explaining that the world needs $75 oil to sustain investment in both conventional production and research into alternatives. Current prices "are wreaking havoc on the industry and threatening current and planned investments", said Saudi Arabia's Oil Minister Ali Al Naimi.

It is a known fact that it is very difficult to replace the entire crude oil demand by an alternative source of energy. We thus have to maintain balance of different energy sources so that crude oil sources are not exhausted completely within a short time frame due to additional global demand and high prices. 

- The author is Senior Research Analyst at Richcomm Global Services DMCC