Oil prices have gained some major downward momentum over the past few weeks. In fact, they’ve plunged 16% so far this month.
An overhang of supplies is one part of the problem, but the biggest force driving the decline is what’s taking place in Europe.
There’s a marginal chance – Credit Suisse Group AG (NYSE: CS) puts it at 15% – that Greece will leave the euro bloc and default on its debt. And there’s an even smaller chance that the euro will collapse as a result.
Obviously, if that happens, a dip in oil prices will be the least of our concerns. Still, such an occurrence would send investors piling into Treasuries and drive the dollar higher in value. Oil would suffer as a result.
But it’s important to remember that this decline in oil prices – no matter how steep it gets – will only be temporary.
There are two key reasons for this:
- First, oil producers have come to rely on high oil prices to cover their expenses. So if prices fall, supplies will quickly start to dwindle, as well.
- And second, lower oil prices will make crude more affordable, thus stoking demand.
Just take a look…
A Delicate Balance
Oil today is far more expensive to produce than it was even 10 years ago. Much of it now comes from deep-sea deposits that are often buried under thick layers of sand and salt or shale, making it difficult to extract.
It takes oil prices upwards of $80 and $90 a barrel to make these projects profitable for oil companies. In fact, energy consultancy, JBC, estimates that the costs of exploring and producing oil from the newest and most expensive wells now costs more than $100 a barrel. Compare that to $50 to $70 a barrel before the financial crisis and $20 a barrel a decade ago.
So if oil slumps down into the $70s, work on many of the more costly reserves will stop and production will decline.
But that’s not all.
Like oil companies, the largest oil-producing nations need high prices to balance their budgets.
Countries in the Gulf Cooperation Council (GCC) rely on oil exports for 80% to 90% of their budgets. And as soon as it became apparent that historically high oil prices were the new norm, these countries increased spending. Combined budgets of GCC nations rose 19.3% to reach $359.1 billion in 2012, compared with actual spending of $301.1 billion in 2010.
Additionally, Saudi Arabia and others vastly increased their public spending and social services following last year’s Arab Spring. Saudi Arabia alone unveiled some $130 billion worth of additional expenditures in the wake of the violent revolutions that toppled several Middle Eastern regimes.
Venezuela and Iran – whose production has also been hobbled by rigid new sanctions – also rely on oil revenue to fund their expansive social programs and energy subsidies.
As a result, most major oil-producing nations need oil prices north of at least $80 a barrel to break even on their budgets.
For example, the United Arab Emirates (UAE) needs oil prices of at least $84 a barrel to balance its budget, according to the International Monetary Fund (IMF). And Bahrain requires prices of $119 a barrel to break even.
As it stands now, Saudi Arabia – OPEC’s leading producer and the only member with a significant amount of spare capacity – is already breaking its self-proclaimed production quota. The country is churning out about 10 million barrels per day, close to its 12.5 million bpd limit.
But if oil prices continue to fall, Saudi Arabia and the rest of OPEC will begin curtailing production. As that happens, the excess supplies that have accumulated will start shrinking, and demand will increase as countries scramble to add to their inventories.
A Breeding Ground for Buying Opportunities
Consider that China’s oil imports in March reached their third-highest level on record. So despite all the talk we’ve been hearing about a slowdown there, China is still sucking up more oil.
It’s not alone, either.
The IEA estimates that global oil demand will expand by 800,000 barrels per day this year and has warned that crude prices will remain high.
The IEA’s assessment of global oil market conditions is broadly in line with the views of OPEC, which earlier this month said oil demand had “stopped its declining trend.”
And finally, a new report by members of the IMF’s internal research team says there could be a permanent doubling of oil prices in the next 10 years.
“While our model is not as pessimistic as the pure geological view that typically holds that binding resource constraints will lead world oil production on to an inexorable downward trend in the very near future, our prediction of small further increases in world oil production comes at the expense of a near doubling, permanently, of real oil prices over the coming decade,” argues the report, entitled “The Future of Oil: Geology v Technology.”
Bottom line: No matter how far oil prices fall from here, the long-term outlook is bullish. In fact, this temporary easement will generate some fantastic buying opportunities. So stay tuned.