The Price We Will Pay for Cheap Oil
The world price of oil – Brent Crude – fell below $84 per barrel on October 15. This was 26% less than the $115 it had reached in June, just four months before. The rise during the spring had many explanations: global tensions in Ukraine, the South China Sea and especially the Middle East with the emergence of the Islamic State, plus a capital crunch challenging the health of the U.S. shale fracking boom. Then suddenly in June, prices started dropping, reaching levels unseen since 2010 (though still high by historical standards – twice that of 10 years ago).
What is going on? Why does the price of oil matter to financial advisors? What might these fluctuations mean to the price and supply of oil for the rest of the decade? Isn’t oil just another commodity?
A primer on oil prices
Oil is unique. There is a tight relationship between energy supplies, especially affordable quantities of oil, and the level of overall economic activity. Simply put, economies stop growing when their use of energy stops growing. The world moves with oil, and petroleum lubricates the global economy. It is not simply a natural resource, but the substance that allows all other systems – from food to cities to (unfortunately) war – to exist at the massive scales of today.
For most of the 20th Century, the world’s supply of oil grew steadily, while the price generally declined and remained low1. This enabled the world’s GDP to expand by a factor of 15, a rate vastly greater than at any time in human history. The opening years of the 21st century have broken with these trends. The price of oil is higher (even adjusted for inflation) than it has been since the opening days of the oil age (except for a few brief periods), but global supplies of oil are growing very slowly, if at all, and economic growth is stalling all over the world.
The booming story of American shale oil development and the prospect of “energy independence” had been a defining narrative driving optimism about our economy since 2009. Many advisors have bought into this story, which depended on enjoying both our new oil and high world energy prices. The current price collapse could be a threat to that part of our prosperity.
Oil extractors need high prices. The cost of getting oil out of the ground has been rising at more than 10% per year for over a decade as the new sources of oil moved to deep water, tar sands and shale deposits. In addition, many nations, especially Russia and those in OPEC, need the revenue from oil to pay their national bills and support the promises made to their people and their militaries. The break-even price for those producers is approximately $110 per barrel for Brent, and that was the regular price from 2010 to this summer, bouncing around in a tight range.
- A quick note of explanation: the most common global price for oil is Brent Crude as traded in London. The most common American price, and the one quoted in the papers and on CNBC, is West Texas Intermediate, or WTI, delivered to Cushing, OK, and traded in New York. Historically, Brent and WTI traded within 1% of each other, but as US and Canadian extraction has grown relative to the rest of the world, WTI now trades at a discount to Brent. The average price paid by US refineries is closer to Brent than to WTI, so that price is what this paper uses.