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The Price We Will Pay for Cheap Oil

October 21, 2014

by Richard Vodra

If these price cuts are a strategic move by Saudi Arabia, the biggest impact will be several years out.  The major international oil companies – Exxon, Shell, Total, BP, and a few others – are the only firms capable of making the financial and technical investments needed for major efforts such as deepwater projects, drilling in the Arctic and developing the Caspian Sea basin.  However, as costs have risen, they now need to receive $130 per barrel of oil for an adequate return on their money.  They were already cutting back on their capital expenditure budgets with $110 oil.  These new lower prices will discourage them further, and the oil that these projects would be yielding at the end of this decade will not appear on the market.

Similarly, U.S. shale oil efforts need prices well above $80, and many operating companies were already under severe cash flow pressures with $100 oil.  The lenders who have financed these companies over the last five years may be reluctant to continue if prices are low or uncertain.  Watch for a decline in new drilling, made worse by the coming of winter to North Dakota.  The threat to oil production in Canada is even worse, as several firms have delayed or cancelled new operations.  A lot of oil that is expected on the market from 2015 to 2020 may “go missing.”

The large oil service companies like Halliburton, Schlumberger, and Baker Hughes have been thought to be a lower risk way to invest in the oil business, but they will be pressured as capital spending is scaled back by exploration and production firms.

The long-term implications for advisors

Cutting back on future oil extraction might seem a good thing for the fight against climate change, because climate activists have been urging steps to keep fossil fuels in the ground.  It is a double-edged sword, though.

Low fossil-fuel prices will slow investment in wind and solar power.  Electric cars, small cars, and hybrids might be attractive if gasoline is $5 per gallon in the US, but less so at $3.   Relatively cheap oil could also hinder China’s investment in promoting more electrified transportation as a way to deal with its pollution concerns.   An investment that assumes the use of fossil fuels, whether a power plant, a pickup truck, or a parking garage without charging stations, will delay the conversion to alternative energy for the life of that asset.

Confusing the climate challenge could be another Saudi goal.  If the energy conversion process away from fossil fuels is done in time, the global community can possibly avoid the levels of CO2 and other climate-forcing substances that we now know will lead to dangerous temperatures and weather in the future.  On the other hand, if that conversion is done quickly, the main assets underlying the economy and society of Saudi Arabia and many other nations, as well as the owners of many energy companies in the US and elsewhere, may become stranded and worth much less.  

Looking ahead, then, it is plausible that the current oil supply glut will lead to a shortage of oil, and higher prices, by the end of this decade, while actions that could have produced useful alternatives may not occur. The current oil price disruption has many possible causes, objectives, and effects, including challenges to the political stability of Russia and many OPEC nations, as well as to the shape of the energy industry over the next decade. 

This is only a preview of the magnitude of changes we should look forward to, economically and politically, in the years ahead.  Financial advisors will have to avoid committing their clients too firmly a specific outcome. 

Richard E. Vodra, JD, CFP, is the president of Worldview Two Planning in McLean, VA. He is also a board member of the Association for the Study of Peak Oil and Gas – USA. He can be reached at rvodra at worldviewtwo dot com.