THE OIL PRICE WAR
GETTING STARTED
In my previous article, I discussed the present situation of the oil prices worldwide and described the factors that have contributed to making oil prices historically low.
In this article, I propose to debate on the future consequences and whether we may see these prices again touching their 52-week highs in the near future or we may see these prices fall further.
BUT WHY DID IT START?
You may ask that if this deal had been going on since a long time, what happened now to change that?
When Saudi Arabia proposed another production cut of 1.5 million bbl/day to stabilise the prices, Russia did not take this positively. They felt that this would be benefitting the U.S. Shale industry that requires high prices to remain profitable ( approx. $50/bbl) while the Russians need much lower prices to remain profitable ( approx. $40/bbl). Therefore, they did not agree to the proposed production cuts.
This has led to the fierce oil price war between Russia and Saudi Arabia.
WHAT LED THE RUSSIANS TO TAKE SUCH A DECISION?
The reason behind why the Russians took this decision lies in the sour relation between Russian oil industry and the U.S. Shale industry.
Ever since the U.S. has become the world’s largest oil producer in the world and its dominance on energy has grown, it has imposed sanctions on other countries and interfered with their oil imports and exports.
Recently the U.S. imposed sanctions on the ‘Nord Stream 2’ which is a pipeline that will carry Natural gas from Russia to Germany. These sanctions were imposed claiming that this threatened the European energy interests but in reality, they did not want Russia to increase its influence on European energy markets.
The Russians were even more angered because these sanctions were imposed just as the pipeline was about to complete. Therefore, it seems that Russia wanted to vent its anger on the U.S. by dropping the prices and thereby hurting the U.S. energy producers.
It seems as if Saudi Arabia is fighting with Russia over market share while Russia is fighting with the U.S.
WILL U.S. ALSO BEAR THE BRUNT?
The Russian’s and Saudi’s have agreed to a historic production cut of about 10 million bbl/day. Though this is a very big production cut, many analysts believe this may already be too late since the reduction in demand is way more than 10 million bbl/day.
The Russians and Saudi’s have made it painstakingly clear that they will only cut production if the United States, the world’s largest oil producer, also takes part in production cut but the U.S. has not expressed any plans on cutting production yet.
Many experts feel this may not be enough to arrest the fall in prices. They also feel that this deal may not go through because it is not so simple for the United States to cut production due to the large number of oil producers in the country and the free-market economic system operating there.
It may be noted that US oil is treated quite differently than the rest of the world’s oil.
Most governments impose taxes on the ‘Ricardian Rents’. What this basically means is that the money made due to the very existence of oil in that area is taken by the Government.
In the U.S., if the land is Federal land, then this money does go to the Government. But if its private land, then the taxes depend on terms mentioned in the contracts.
This essentially means that oil produced in the US maybe some of the most profitable oil produced by the large oil corporations, and oil produced in the U.S. would be the last to be cut for production.
This situation is worsened by the fact that the U.S. cannot just ask the private oil producers to limit their production as this would violate antitrust laws. So, the only option remaining is that the U.S. limits the production of the state-owned companies to appease to the demands of Russia and Saudi.
And without production cuts from the U.S., the deal will most likely fail and be postponed until the second or third quarter of 2020, when the global storage capacity maxes out.
Domestic producers in the U.S. have been trying to get the U.S. government to impose tariffs on the imported oil so as to make domestically produced oil cheaper and favourable.
WILL U.S. OIL COMPANIES SHUT DOWN?
Now the question is that if U.S. companies require such high prices to remain profitable, will they lose money and will they have to shut-shop?
The answer to this is a very interesting one because it won’t be the total costs that would decide who goes bust first, rather it is the running costs.
The wells that have been already drilled are very cheap to pump oil from. So even if a well is accruing losses overall, including the original drilling costs, they’ll still keep pumping up until you have positive cash flow from doing so. What this means is that the price to push out the current producers is way lower than the price which stops new entrants from coming on-board. Therefore, the conclusion is that oil prices may fall way beyond profitability levels before there are any production cuts.
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