Reevaluating Oil

A Historic Low

The most critical collapse of oil prices in history occurred in the mid-1980s, and was the harbinger of a new era. Experts believe that the price drop inflicted a fatal blow to the Soviet economy and led to a complete collapse of the country, as well as the socialist bloc in Eastern Europe, which the Soviet Union was no longer able to finance. Conspiracy theorists believe that the crisis was deliberately orchestrated by the United States, and set up by their ally Saudi Arabia. According to Bloomberg, Saudi Arabia declared a sudden decision to regain oil market share after letting production fall from 9 million to 3.2 million barrels a day in the period between 1980-1985. Following the King’s decision in December 1985, Saudi Arabia’s oil production increased sharply and the oil market collapsed in just a few short months. Though a barrel of oil was peaking at $31.72 in November 1985, the price was closer to $10 by March 1986.

Two oil-producing countries incurred major losses at that time. The Soviet Union, whose budget relied heavily on oil revenue, could no longer continue to compete with developed countries in the science, technology, and defense industries. Over the next five years, the country found itself in a deepening crisis, until finally the Soviet Union ceased to exist. However, the actions of Saudi Arabia also hurt the United States. Unemployment in the main oil-producing states soared. Reports by Bloomberg showed that unemployment rose to 8.9% in Oklahoma and to 9.3% in Texas, which was higher than the 7% national average. According to the Energy Information Administration, oil production in 1986 fell by 8.3% in Oklahoma and by 7.1% in Texas. “There was just a flood of equipment on the market,” said James Richie, co-founder of Kruse Energy & Equipment LLC. Richie held 86 oilfield gear auctions that year, more than twice the usual number. “In 1986, that equipment was bringing pennies on the dollar,” he said in an interview with the Energy Information Administration. Michael Lynch, who is president of Strategic Energy and Economic Research and has covered the oil sector for 37 years, explained that there was a big price collapse in the oil market in 1986, and the industry did not see it coming: “It put a lot of companies out of business. You just don’t forget it. It’s part of the cultural memory.”

Lower oil prices will fail to give a significant boost to global growth in the next two years, said Moody’s Investors Service in its quarterly Global Macro Outlook report, published in February. Its forecast is based on the assumption that this year’s oil prices will average $55 a barrel, rising to an average of $65 a barrel in 2016. Moody’s analysts say that oil prices will remain near current levels because supply and demand conditions are unlikely to undergo a marked change in the next two years

But at the time, most of the countries that would go on to form BRICS had barely started integrating into the world economy. Russia was still part of the Soviet Union, China had separated itself from the West with an impregnable barrier built by its communist leadership, and India and South Africa were still very much third-world countries, getting aid from their ‘big brothers,’ the USSR and the US.

A New Challenge

Some 30 years after the largest oil crisis in history, the global economy is facing a new one. But the world itself has changed beyond recognition. The meteoric rise in oil prices from $5-7 per barrel at the end of the 1990s to more than $100 in 2007-2012 has brought about a new economic reality. Russia and Brazil, whose economies are heavily dependent on oil prices, were among the fastest growing countries. At the same time, world consumption spurred the development of industries in India and China, which also made those countries very attractive to global capital. However, everything changed drastically in the second half of 2014. The price of Brent crude oil declined sharply, and by mid-March was around $60 per barrel.

Some 30 years after the largest oil crisis in history, the global economy is facing a new one. But the world itself has changed beyond recognition. The meteoric rise in oil prices from $5-7 per barrel at the end of the 1990s to more than $100 in 2007-2012 has brought about a new economic reality. Russia and Brazil were among the fastest growing countries, while world consumption spurred the development of industries in India and China, which have become attractive to global capital

Economists and industry experts are sharply divided as to why the price of oil collapsed. Some believe that it was because OPEC did not reduce oil production in the Middle East last fall. Earlier this year, VYGON Consulting conducted a survey of industry officials, oil company executives, and experts when preparing its report The World Oil Market: from ‘manual control’ to the ‘invisible hand.’ The interviewees agreed that OPEC’s decision had a negative impact on the price of oil, but they also named other causes of the current crisis. The cost of crude oil was affected by global overproduction of oil and by price fixing among the world’s largest oil companies, which thwarted the development of alternative fuels, such as shale oil.

Survey participants agree that the price of oil will fluctuate between $60-80 per barrel over the next two years. The average price will likely hover around $59 in 2015. By 2017, it will have likely risen to an average of $78, and it is thought it will not reach a level above $90 (not adjusted for inflation) until 2035. In another possible scenario, the price of oil could rise to $61.70 per barrel this year, up to $82.50 by 2017, and then it could fall to $67.50 per barrel by 2035. Some oil companies are more optimistic. In early February, Leonid Fedun, Vice President of Lukoil, said that by the end of this year we will see a barrel of oil at $100. He justified this by saying that the price war unleashed by Saudi Arabia and OPEC would lead to a reduction in oil production, in particular in the United States, which in turn would affect the price.

Asia: the Winners
and the State-Controlled Economy

“Lower oil prices will lead to sizeable real income shifts from oil-exporting to oil-importing developing countries. For both exporters and importers, low oil prices present an opportunity to undertake reforms that can increase fiscal resources and help broader environmental objectives,” said Ayhan Kose, Director of Development Prospects at the World Bank (as quoted by the World Bank’s press office).

Lower oil prices will fail to give a significant boost to global growth in the next two years, said Moody’s Investors Service in its quarterly Global Macro Outlook report, published in February. Its forecast is based on the assumption that this year’s oil prices will average $55 a barrel, rising to an average of $65 a barrel in 2016. Moody’s analysts say that oil prices will remain near current levels because supply and demand conditions are unlikely to undergo a marked change in the next two years.

In its report, Moody’s said that only a few of the G20 countries will be able to benefit from lower oil prices. In particular, it singled out India as one of the winners. The World Bank, in its Global Economic Prospects report published in January, also pointed to India as one of the main beneficiaries of cheap oil. “The lower oil price, which is expected to persist through 2015, is lowering inflation worldwide and is likely to delay interest rate hikes in rich countries. This creates a window of opportunity for oil-importing countries, such as China and India. What is critical is for nations to use this window to usher in fiscal and structural reforms, which can boost long-run growth and inclusive development,” said Kaushik Basu, World Bank Chief Economist and Senior Vice President. According to Basu, India’s economic growth in 2016-2017 is expected to rise from 6.4% to 7% this year. The World Bank said that last year, the country’s economy increased by 5.6%.

Moody’s analysts were less optimistic about China’s prospects because of the high degree of government influence on economic processes in the country, which does not allow it to take advantage of being an importer of oil and oil products. Despite the fact that China is the largest consumer of energy, low oil prices will not save the country from the economic slowdown. China’s energy taxes are high and government control over tariffs in sectors like transport and energy is strong, explained Moody’s analysts. Moody’s forecasts that China’s GDP growth will fall from 7.4% in 2014 to below 7% in 2015. That number is forecasted to drop to 6.5% in 2016.

According to the World Bank’s report, China is indeed experiencing a carefully controlled slowdown to a continued high growth of 7.1% this year versus 7.4% in 2014. The Bank’s analysts predict the Chinese economy will grow by 7% in 2015, and by 6.9% in 2017. Growth will slow down due to the fact that the Chinese government is pursuing structural reforms of its economy, gradually pulling out fiscal stimuli of individual industries and reducing non-bank lending, according to the World Bank.

The World Bank’s report indicated that South Africa, also a major energy importer, will be able to improve its economic situation as well. In particular, the low oil prices will help South Africa reduce inflation. However, World Bank data revealed that the economic growth rate went up slightly last year to 4.5% and is expected to remain flat next year, and then to rise gradually to 5.1% in 2017, supported by increased agriculture production, buoyant services, and infrastructure investment.

Russia: Failed Expectations

Persistently low oil prices will weaken economic activity in the exporting countries. The World Bank predicts that the growth of the Russian economy will contract by 2.9% in 2015, barely getting back into positive territory in 2016, when growth is expected to reach 0.1%. Moody’s forecasts a deep recession in Russia that will last until 2017.

The signs are already there, above all in the form of the ruble’s devaluation against the world’s reserve currencies, the dollar and the euro. Since the beginning of December 2014, the ruble has lost 50 percent against the dollar and euro.

The consequences of lower oil prices became apparent at the end of last year. The falling price of oil, the main source of income for the Russian budget, dragged the ruble down and accelerated inflation. The exchange rate fluctuated wildly in December, something that had been unprecedented for the last 10 years – the dollar reached 78 rubles and the euro crossed the 100-ruble mark. It was followed by a harsh response from the global market.

As early as 26 January, Standard & Poor’s downgraded Russia’s sovereign rating to non-investment grade – or as stock market professionals call it, ‘junk’ grade. Moody’s followed suit in late February, predicting Russian inflation to be at 22% this year. These actions, and both agencies’ warnings about Russia’s potential debt default, have almost entirely obstructed Russia from borrowing internationally.

“Because of falling oil prices as well as EU and US sanctions, Russia has already lost about $200 billion,” said Russian Finance Minister Anton Siluanov in an interview with CNBC at the end of January. “The drop in oil prices had the biggest impact,” he admitted.