Impact of Increased Oil Prices

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Impact of Increased Oil Prices

West Texas Intermediate (WTI) crude oil is sourced from the United States (U.S.) and serves as the benchmark for oil produced in the Western Hemisphere. Brent crude refers to oil from the North Sea and serves as the benchmark for oil produced in Africa, Europe and the Middle East. OPEC generally targets the Brent benchmark. Brent and WTI prices generally move together with a correlation close to one. Since early 2016, the price of Brent has been higher than that of WTI.

Potential Impact of Record Low WTI Prices

Impact on U.S. Economy

  • When global oil prices recently dropped by as much as 30%, U.S. Treasury bond yields recorded record lows as investors sought havens. The 10-year yield fell below 0.5% to a record low in the largest rally for U.S. Treasury debt in over a decade, and the 30-year yield fell below 1%, bringing the entire U.S. yield curve below that level for the first time.
  • U.S. consumers would likely see lower gasoline prices. When oil prices drastically dropped 20% in late-2018, American drivers were saving about $80 million a day due to a $0.20 drop in the price of regular gas from early October 2018 to November 2018.
  • Although businesses generally like lower oil prices, they may rein in spending and hiring if they believe the price decline will result in economic slowdown, potentially leading to recession.
  • American oil producers would likely suffer from significant price decline. According to a global-energy expert at the Center for Strategic and International Studies, “For U.S. producers, sustained prices below $50 would undoubtedly be problematic for all but the most efficient operators.”
  • According to oil.com, purportedly "the most popular energy news site in the world," a sustained depression in oil prices may lead to loss of employment in the energy sector (which historically yields relatively high-paying jobs), reductions in capital expenditures and a decline in corporate profitability. Any economic benefit resulting from lower prices for consumers may be far outstripped by these effects to the energy sector.
  • According to the president of the consulting firm Rapidan Energy Group, “The current drop in oil prices is a net benefit to consumers, but there’s always a possibility they can fall too low for their [own] good... As we saw in 2015 and early 2016, imploding crude oil prices to below $30 per barrel can threaten to cause economic busts particularly in regions where we are actively producing shale oil."
  • The president of the Texas Taxpayers and Research Association has estimated that Texas loses $85 million per year for every $1 decrease in oil prices.
  • The chief economist for Bloomberg Economics notes that the U.S. "in the past had a lot to gain from lower oil prices, now has something to lose."

Impact on Global Economy

  • When global oil prices recently dropping by as much as 30%, global stocks dropped precipitously, with major European indexes losing over 6% in value and the U.S. S&P 500 losing 5%. A strategist at Deutsche Bank sees these effects as the market pricing a global recession.
  • Major oil-producing nations stand to lose the most from lower oil prices. Russia claims to budget based on about $40 per barrel. Its $150 billion National Wellbeing Fund can apparently cover lost revenue from sustained prices at $25-$30 per barrel for up to 10 years.
  • The Gulf countries produce oil at the lowest cost, but sustained prices below $70 will hurt their ability to balance their budgets due to extravagant spending habits.
  • Large net importing nations such as China, India and Germany stand to benefit greatly from falling oil prices — as do all consumers from lower gasoline prices.

Impact on Small, Independent Shale Producers

  • According to Ian Nieboer, a managing director at consultant Enverus, shale companies need prices in the low $40s per barrel to cover direct costs. Sustained U.S. prices in the low-$30s range will start "to look more lethal” to companies.
  • As noted previously, the president of the consulting firm Rapidan Energy Group noted, "As we saw in 2015 and early 2016, imploding crude oil prices to below $30 per barrel can threaten to cause economic busts particularly in regions where we are actively producing shale oil."
  • Frank Gunter, professor of economics at Lehigh University, noted that WTI prices of around $50 per barrel, allow drillers to recognize a profit, thanks to dramatic realized efficiencies in fracking. "Today the break-even point, the price at which all costs of production are covered, sits around $30 to $40 per barrel, down from $70 in 2012."
  • Other analysts believe that U.S. shale companies are debt-laden and have a breakeven price point in the high $40s. According to Commerzbank, "Many US fracking companies already had their backs to the wall before the price slump due to high debts and financing difficulties."

Likelihood of Price Reaching $20

  • On March 8, 2020, WTI fell to $31.13 per barrel, its second worst day on record. Brent crude fell to $34.36 per barrel. Before settling at those levels, each slid by over 30%, with WTI going as low as $30 and Brent dropping to $31.02.
  • According to Ali Khedery, former senior Middle East advisor to Exxon and currently CEO of strategy firm Dragoman Ventures, "$20 oil in 2020 is coming." As causes, she pointed to failed/failing petro-kleptocracies, such as Iraq and Iran, as well as the current COVID-19 global crisis.
  • Analysts at Eurasia Group put the probability of an eventual output agreement between Saudi Arabia and Russia at 60%. This would greatly lessen the chances of $20 per barrel oil.
  • According to Vital Knowledge founder Adam Crisafulli, "Saudi Arabia can’t tolerate an oil depression — the country’s fiscal breakeven oil prices remain very high, Saudi Aramco is now a public company, and MBS’s grip on power isn’t yet absolute. As a result, the [government] won’t be so cavalier in sending oil back into the $30s (or even lower).
  • Goldman Sachs slashed its Brent Crude estimates to $30 a barrel in the second and third quarter of 2020 “with possible dips in prices to operational stress levels and well-head cash costs near $20/bbl” due to demand shock from the COVID-19 outbreak and current the current OPEC+ impasse. Goldman Sachs believes low cost producers will continue to increase supply from their excess capacity "to force higher cost producers to reduce output."
  • As of March 11, 2020, the U.S. Energy Information Administration (EIA) expected WTI prices to average $38.19 per barrel in 2020, down from an average of $57.02 per barrel in 2019, and then rebounding to an average of $50.36 in 2021.
  • The lower bound of the 95% confidence interval of NYMEX WTI futures price does not reach as low as $20 in the near future.

Contingency Plans for Small, Independent Shale Producers

  • Four years ago when OPEC last drastically increased supply, U.S. shale firms were able to weather the storm because they were able to find investors willing to buy their debt and finance their continued operations. Now, according to Richard Spears, vice president of oilfield consultancy Spears & Associates, firms are likely to halt completion of new wells and cut back on production levels.
  • As noted previously, the common reaction of shale producers to survive the low oil prices resulting from the OPEC+ breakdown is to cut spending at least in the short term.
  • Shale companies attempt to protect their revenue streams from unforeseeable events with hedges such as buying options. Unfortunately, no options were priced to take into account the latest fall in prices. In the future, it may be possible to account for greater volatility in hedging schemes.
  • The Federal government appears very conducive to assisting U.S. shale companies survive plummeting oil prices. "White House officials are alarmed at the prospect that numerous shale companies, many of them deep in debt, could be driven out of business if the downturn in oil prices turns into a prolonged crisis for the industry." Federal aid would likely include low-interest loans.

Research Strategy

Most information was accessible via regular Internet searches. Online trade publications and market research were also consulted. We focused on reactions to the latest drop in oil prices earlier this month and speculation of what was to come.
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