The Oil Glut

Global oil prices are now near five-year lows. US producers are feeling the pain; they are not alone. Low oil and natural gas prices are causing companies and governments throughout the world to reexamine their budgets, rethink their priorities and, in some cases, make major policy decisions based on the possibility that significantly higher prices may be a long time coming, if ever.

In July of last year, oil was trading above $100 per barrel. Since January of 2015, the average price has been less than $50. The new technology of horizontal drilling combined with multiple stage hydraulic fracturing has unlocked literally billions of barrels of oil from tight reservoir rocks. Since 2005, US oil production has been increasing at an astonishing rate. The US is now the second largest producer in the world, close behind Saudi Arabia. “This is a historic turning point,” historian Daniel Yergin said. “The defining force now in world oil is the growth of US production.”

The result has been the development of a worldwide oil glut that has hammered commodity prices. Here in the US, lower prices have idled half the fleet of drilling rigs, necessitated the layoffs of thousands of workers, and are wreaking havoc among the independent oil and gas operators who depend on operating cash flow to fund their businesses. Around the world, the glut is creating some significant geo-political ripples.

As was recently pointed out in a talk by Ken Hersh, chairman of Natural Gas Partners, the world is suddenly shifting from one of energy scarcity to one of energy abundance. “It’s a world in which the economics of scarcity, whose rules are determined by producers, are being replaced by those of consumers, who are benefitting from lower prices,” Hersh said.

For American motorists, the price-drop is providing a windfall. The average price of a gallon of gas is more than a dollar lower than it was a year ago, a huge savings to consumers who are putting much of it straight back into the economy, buying clothes, electronics, restaurant meals and other items they might not otherwise splurge on.

Worldwide, lower prices could imperil the economies of petro-states such as Venezuela, Iran and Russia. Analysts believe OPEC, whose 12 members account for around one-third of the world’s oil supply, is trying to drive some US shale producers out of business. Saudi Arabia, which effectively leads the cartel, has so much wealth it can handle significant losses, but for countries whose economies rely heavily on high oil prices, the outlook is much bleaker.

The West now has more leverage over rogue petro-states. Until the US made the accommodative agreement with Iran over Iran’s nuclear program, Iran could no longer rely on high oil prices to soften the impact of economic sanctions. For a time, the US had an opportunity to make a favorable deal. Similarly, Russia now has more reason to pull back on its aggression toward its neighbors, and even to make sales of natural gas to China, which it might not have previously considered. Whether Mr. Putin ultimately accedes to the pressure to lessen his belligerency toward Ukraine is still to be determined.

Venezuela is in even worse financial straits. Inflation is a staggering 60%, and currency controls have generated scarcity of basic needs. In the past, President Nicolas Maduro, and his predecessor, Hugo Chavez, hid the perilous state of Venezuela’s finances behind populist policies funded by vast oil revenues. Now political upheaval is a real possibility.

The US benefits in other ways by its new largess. Oil imports are, and have historically been, the largest component of our foreign trade deficit. Every barrel produced domestically replaces one otherwise imported. Since 2005, when production of shale oil began coming on the market in significant volumes, the US has reduced its dependence on oil imports from 72% to 16%, an amazing accomplishment.

The US has spent billions of dollars in military support to protect oil transport ships in hazardous areas, and to provide military equipment and personnel to those countries considered critical to a continued secure supply. With less dependence on imports, the need for a continued high level of support might be reduced.

Further, with increasing supplies, the US dollar becomes stronger, and our government’s hand is strengthened in negotiations with foreign governments. We have the opportunity to regain our reputation as a stable and reliable partner to our friends and allies, and to be less required to deal with unfriendly regimes merely because we need to purchase their oil.

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