By Jac Laubscher, 16 January 2015
The sharp decline in the oil price in response to a changing balance between demand and supply once again demonstrates the danger of extrapolating recent trends when forecasting the future. It is not long ago that “peak oil”, viz. the view that the rate of oil extraction has reached its peak and will decline from then on until oil reserves have been fully depleted, putting upward pressure on prices, was the dominant theme in oil markets.
The prevailing view was also that as far as oil reserves were concerned the low-hanging fruit had been picked and that marginal production costs would keep on increasing as producers were forced to exploit reserves that were more difficult and expensive to reach, for example at very deep sea levels. Brent oil was trading at approximately $150 per barrel at the time and the expectation was that oil prices would remain high. So once again a doomsday scenario regarding the depletion of the resources offered by planet earth has proved to have been adopted prematurely!
However, by implication one should also avoid the trap of extrapolating the current low prices into the distant future. Just as $150 was not an equilibrium price, the reigning low price of around $50 is also not a stable equilibrium.
It will take some time for the market to adjust to the new reality and find a sustainable equilibrium. What we are witnessing at the moment is a classic fight for market share that will continue until sufficient high-cost production has been removed from the market to bring supply and demand into balance. Estimates of the marginal cost of producing a demand/supply-balancing barrel of oil vary but tend to converge around $80 and oil prices lower than this would therefore appear to be unsustainable in the long run.
For some people the slide in oil prices demonstrates the game-breaking power of technological development. For others the slide is merely cyclical, viz. the result of reduced oil demand because of a weaker economic outlook for Europe and China in particular.
For the first group previous high prices and increased awareness of environmental damage, in particular the challenge of global warming because of the emission of greenhouse gases, served as encouragement for a reduction in the resource intensity of economic activity by lowering energy requirements and shifting to renewable energy sources. But the greatest technological response was on the supply side where the development of fracking methods to exploit the possibilities of shale oil added a completely new dimension to the supply of oil, undermining the dominant position of OPEC, in particular Saudi Arabia, in setting prices.
(It is interesting to note that in an article on “The Innovative State” by Mariana Mazzucato in the January/February 2015 edition of Foreign Affairs, she points out that the 3-D geologic mapping technology used for fracking operations was developed by Sandia National Laboratories, part of the US Department of Energy, as long ago as during the 1970’s.)
For the second group lower oil prices are a temporary phenomenon, with weak primary demand being exacerbated by inventory reduction in anticipation of higher interest rates.
The biggest impact of sharply lower oil prices will be on the economic and fiscal position of oil-producing countries. This highlights the wisdom for commodity producers of having sovereign wealth funds in order to smooth the long-term impact of their commodity wealth on their econ-omies. Countries that rely excessively on taxes from the oil industry to balance their fiscal books will be particularly hard pressed by the recent price slide in the absence of the stabilising influence of such as fund.
The implications of lower oil prices for South Africa are numerous and mostly advantageous. The immediate impact will be to reduce inflation via lower fuel prices and possibly less rand weakness as a result of an improvement in the current account balance caused by reduced oil imports (although one should bear in mind that coal prices are linked to oil prices through the partial substitutability of oil and coal, reducing the value of South Africa’s coal exports.)
This should in turn restrain the South African Reserve Bank from raising interest rates. However, the Monetary Policy Committee will have to bear in mind that this is a one-off positive shock that will in all likelihood be partially reversed at some future date. Watching the trend in core inflation, viz. in prices excluding energy and food, will therefore become more important as a true reflection of inflationary pressures and its current close relationship with headline inflation (in November 2014, the latest available numbers, both measures were running at 5,8%) will probably not hold.
Although not enough to solve Eskom’s financial crisis, lower diesel prices should assist Eskom in dealing with its cash crunch given its abnormally high use of diesel fuel to feed gas-driven generators, while further cost savings should be achievable once long-term coal supply contracts can be renegotiated.
South Africa’s strategy for expanding future energy supply will also have to reckon with the changed outlook for carbon fuels. Not only will the position of nuclear power relative to coal-fired power stations be affected, but the viability of exploiting shale-gas deposits in the Karoo will have to be reconsidered and the abnormally high free-carry (20%) the government intends to claim looks more onerous by the day.
Lastly, lower fuel prices will create space for the government to fill part of its revenue gap by increasing the fuel levy in the coming National Budget by more than what would have been acceptable under normal conditions. The fact that last year’s increase in the fuel levy was limited to a mere 12c/litre, resulting in a drop of nearly 2 percentage points in the ratio of taxes to pump prices to 24,2%, also points to a more hefty increase this time round.
The 12c/litre increase in 2014/15 was expected to contribute an additional R2,565 billion to government revenue. Upping the fuel levy increase by, for example, 36c/litre could therefore cover a third of the additional tax of R15 billion that needs to be raised in the coming fiscal year as indicated in the Medium Term Budget Policy Statement last October.
However, it is still an open question at what level oil prices will eventually settle.