Falling oil prices: this time around, it will be different

The oil price collapse that started in October 2014 has yet to run its course but this much is already clear: it will be seen as a historic event.

The market has never seen anything like this before. The rout in 2008-09 was arguably more dramatic, but led by factors outside of the oil market. It was a result of a financial crisis and a sharp contraction in economic growth, which sapped demand for oil.

But this time it is different and not just because of the relative scale of price moves. The 2014 sell-off originated in the oil market: first from rising inventories as demand weakened and unplanned outages eased; and then when Opec — effectively Saudi Arabia — decided not to intervene and let market forces rule.

One of the reasons Saudi Arabia relinquished its role as a swing producer is precisely because of these differences — in 2008, external factors caused the drop in demand, which Opec then took action to correct. This time around, the problems came from within.

Production cuts by Saudi Arabia to shore up prices would therefore only result in the kingdom losing market share given the inability and unwillingness (for various reasons such as lack of revenues or high social spending) of other Opec and non-Opec countries to reduce output.

Inevitably, the decision by Opec to “roll over” the existing 30 million barrel a day production quota at its November meeting revived old debates about its relevance and importance in the market, especially in light of the growth in US tight oil, or shale output.

But these exchanges usually ignore one simple point. The decision to not intervene is a brave one given that it signals a departure from what economic theory would suggest an oil producer should focus on — revenues.

Saudi Arabia is giving up billions of dollars of revenues in the short term and running a $39 billion budget deficit in 2015, in an effort to retain market share. It is betting a period of lower prices (which it can withstand given plentiful foreign exchange reserves) will shake out some high cost producers.

Indeed, Saudi Arabia’s oil minister has stated openly that irrespective of price levels “be it $40, $30 or $20 per barrel” they would not reduce output.

For the industry, not only has the recent collapse broken a long period of high and stable oil prices, it has also been a huge wake up call especially in light of Saudi Arabia actively talking down the market, something which is unprecedented.

The general assumption since the global financial crisis, when Opec cut supplies by 3 million barrels per day, led by Saudi Arabia, was that the kingdom would ensure prices stay within its desired range, which eventually settled at $90-$110.

That complacency meant US tight oil producers went on a tear, cranking up capital expenditure and racking up debt, while the oil majors focused on projects in ever more challenging locations, resulting in soaring costs. According to our analysis, more than a third of global oil production is uneconomic (although these will not necessarily be shut in) at today’s prices and more than 2 million barrels per day of new projects are at risk.

So, Opec’s decision to not intervene and Saudi Arabia’s stubbornness (if one may call it that) has taught the market several lessons: that Opec and its biggest producer should not be taken for granted. That it may be willing to pursue longer-term objectives, even at the cost of near term revenue.

The consequences are profound. No boardroom discussion at an oil company will ever be the same again. Pursuing projects at any cost, something already being questioned by investors, will now be more closely scrutinised by management if Saudi Arabia is no longer the price stabiliser people have expected it to be.

And if these costly projects are not undertaken, the steady growth in non-Opec output will slow. Years of near two million barrels a day of supply growth will be few and far between in the future; the steady state may well be 0.5 million barrels a day at best.

Amrita Sen is chief oil analyst at Energy Aspects, a London-based consultancy

Financial Times