Do Falling Oil Prices Concern You? They should.
Oil closed at just over $81/bbl. today (October 13th, 2014), a four year low. Many remember the 1980s when oil dropped as low as $10/bbl. and the “oil patch” economy went into a depression! Total U.S. crude oil production averaged an estimated 8.7 bbl/d) in September, the highest monthly production since July 1986, (Per EIA.) Year over year, the U.S. imported nearly 1 million barrels less of crude oil.
Depending upon your perspective, falling oil prices are good or bad. No matter which view you hold it is a development you should be concerned about. Outside the energy industry, falling prices lower the cost of virtually everything. According to the U.S. Energy Information Administration, 92% of transportation costs are driven by oil prices.
So what’s happening to the crude oil market?
Briefly, U.S. oil production is higher than ever before, demand is weak and the largest OPEC producers are cutting prices to hold market share and turn off higher cost producers in the medium term.
It’s been widely reported that Middle East producers signaled they would keep output high to defend market share even if that meant lower prices. Saudi Arabia has privately told oil market participants it can accept oil prices between $80 and $90 a barrel. China increased crude oil imports by 9.5 percent from August, lending limited support to prices, but they often increase reserves when prices are low, and real demand growth is likely to be more modest. The forecast for European demand is poor in France and Germany due to weak economies.
According to chart analysts, oil prices could be on the brink of sliding another $10 or more. They say a drop of over 20 percent since June has wiped out key support levels and the next support level for prices could be another $10 lower. According to Daniel Sternoff, Senior Managing Director at consultancy Medley Global Advisors, “You have the reality of an increasingly crowded market for mid-sour barrels in Asia,” and “I wouldn’t say price war, but there are clear signs of more competitive pricing.”
From the energy capital in Houston, Texas with my CFO hat on I see a number of risks and an opportunity that we are talking to our clients about. First, the higher cost U.S. shale plays become uneconomical below $80/bbl. The map shows the major shale plays and the chart displays the oil price required to meet a 15% ROI by field. If your business is overly concentrated with a company focused in one of the higher cost shale plays it may be time to reevaluate your risk.
Credit Risk with U.S. firms that have concentration in the higher production cost U.S. shale plays
Firms with exposure to Russia and other countries whose economy is highly correlated to oil.
The IMF has stated that Russia should try to build a reserve fund of 7% of GDP. Depending on how you look at Russia’s hard currency reserves, it has between $87 billion to over $400 billion to defend its currency against a drop in exchange rates to the dollar. The Russia times reported that $57 billion was used in two months to defend the Ruble after the Crimean invasion. Since then, capital flight has accelerated and U.S. based companies are finding it increasingly difficult to do business with a government that is going back to a “Cold War” stance. As Oil prices slide and stay in the $80 range Russia will likely enter a recession and burn a lot of hard currency in a feeble attempt to prop up the Ruble. Shearing from Capital Economics, calculates that at an oil price of $85 per barrel, Russia would run a deficit of around 3 percent of GDP – enough to wipe out the whole of the Reserve Fund in a single year.
Exposure in Financial Markets
As the impact of that overall cost reduction in manufacturing and transportation begins to filter slowly into the global economy, it will go some way towards increasing economic activity. This will help provide some economic stimulus that in the medium term creates additional demand.
At Rand Group, we not only are interested in how to use technology to help your firm achieve its goals, but also strive to understand the economic and global issues that affect your business so we can assist you in using technology to see what’s around the next curve in the road!
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