The oil price declines of the past four months are almost identical to what transpired over a similar period in the first and second quarters of 2012. The global markets expressed confusion as to the economic significance and impact of falling oil prices then and are doing so again now. I wrote about this issue in May 2012 and I encourage you to read it again as a preface to today's column.
On Feb. 24, 2012, West Texas Intermediate (WTI) hit a cyclical peak of $109.39 per barrel. Over the next four months, the price fell to $77.72 on June 28, a decline of about 29%. Similarly, on March 9, 2012, BRENT reached a cyclical peak of $128.08 and fell to a trough of $88.69 on June 25, a decline of about 31%.
Moving to the current environment, WTI peaked on June 10, 2014, at $107.95 and has declined over the past four months to about $87.30, a decline of about 19%. On June 19, 2014, BRENT reached a cyclical peak of $115.19 and is now about $91, an approximately 21% drop.
Although the move over the past few months has not been as severe as 2012, we don't know if it has yet been concluded, although I expect that it hasn't. More importantly, it's irrelevant.
In both cases, oil prices fell below the fiscal break-even of most of the largest suppliers with state-owned oil industries, mostly members of the Organization of Petroleum Exporting Countries. In areas of the world where the industry is privately owned, the price has fallen to or below the marginal production costs for the most expensive oil to access.
Of the 12 members of OPEC, only two have fiscal break-even prices below current prices: Qatar and Kuwait, at about $60 and $70, respectively. It then leaps to about $100 for Angola, the United Arab Emirates and Saudi Arabia, and again to $115-$125 for Libya, Venezuela, Ecuador, Iraq, Nigeria and Algeria. The break-even in Iran is around $150.
More importantly, even at the cyclical highs, the majority of OPEC members are just breaking even; and even more importantly, their break-even costs are increasing faster than the long-term average for oil price increases because of the debt being taken on to meet fiscal needs when the price of oil declines. Further, the rate of growth in real economic activity globally is lower than the increase in oil prices necessary to meet the fiscal break-even point.
It is the increasing fiscal break-even required of traditional oil suppliers, like the OPEC countries, which allows the price of oil to remain slightly above the break-even production price for alternative oil supplies, like those in North Dakota's Bakken, and the Permian Basin, and Eagle Ford in Texas.
That is a temporary situation, however, on two fronts. The cost of accessing oil from these fields is not decreasing; it is increasing. The economies of scale expected to reduce the cost of accessing this oil coupled with increases in technology expected to reduce the cost of doing so are not happening.
In net, the world is now at a place where there is a permanent mismatch between what oil producers must sell for and what oil consumers can afford to pay -- and that gap is only going to increase.
As this gap widens, because there is no substitute for oil, the production of it and the price it commands in the market will fluctuate. As prices rise above economic viability due to increases in global demand, the consuming economies will have to offset the economic drag caused by issuing debt, both at the sovereign and private levels. This will also cause an increase in production, which will then cause a temporary glut, which will cause prices to fall. The reduction in prices then causes production to decrease and forces the producers to take on more debt to offset the fact that they are below production or fiscal break-even.
This process has been playing out for several years and will continue to from now on, with both consumers and producers taking on debt faster than economic growth. This was a warning from by The Club of Rome made 42 years ago in the seminal paper "The Limits to Growth."
At this stage, there is no corrective action possible to cause oil to become economical again. The producers can't reduce fiscal outlays as it risks civil unrest and political instability. Global consumption can't be reduced by way of technological innovation because the more efficiently oil is consumed, the greater the aggregate consumption of it is. This is called the Jevons Paradox, which I wrote about in September. In future columns, I'll address the effect of this on capital markets.
