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Where's all the stimulus from the 50% drop in oil prices?

The fall in oil prices heralds a momentous shift in world energy markets from the BRIC era of emerging markets (Brazil, Russia, India and China) to the Shale Era.     

     Yet there are two continuing puzzles about the price collapse. First, the 50% fall in prices has not been the global economic stimulus that might have been expected. So far, at least, it has not been a Fourth Arrow for the world economy. Is this telling us something about deeper troubles ahead for the world economy?

     The second puzzle concerns geopolitics. The oil market is usually very sensitive to geopolitics. Geopolitical risk is high now: The Middle East is in crisis. The West's relations with Russia are the worst they have been since the end of the Cold War; the stand-off in Syria makes things even more dangerous. Meanwhile, tensions are rising in the South China Sea. Yet none of this has caused oil prices to spike. The reason is that none of these factors have yet directly threatened the flow of oil. To put it simply, while there is a surplus of geopolitical risk, the surplus of oil is much greater, at least for now.

     As we consider the forces of supply and demand that are keeping oil prices low, we need to remember that a geopolitical crisis or a more direct threat to the flow of oil could unexpectedly intervene in the market and send prices up again.

     As it is, however, the collapse certainly marks a historic change in world oil markets -- from strong demand and tight supplies to ample supplies and weaker demand growth. Put simply, the world is in a much better position in terms of oil than was the case just a few years ago.

     For the decade that began in 2004, the dominant theme in the world economy was emerging markets. That's where economic growth was happening. During those years, China's gross domestic product increased two and a half times and India's doubled. Compare that to the growth of the U.S. economy, 16%; the European Union, 10%; and Japan, 6%.

     The rapid growth of emerging markets generated what became known as the commodities supercycle. It seemed that demand would only grow and prices would only increase, whether you were talking about iron ore, copper or oil.

     Oil companies and other commodity producers hastened to increase capacity to meet the unexpected surge in demand that came with rapid urbanization and industrialization. Oil prices rose from $20 to $25 a barrel at the beginning of this century to around $100 a barrel from 2011 to 2013. More than anything else, it was China's enormous appetite for commodities that drove up prices. Between 2003 and 2013, China accounted for 45% of all growth in global demand for oil. Over roughly the same period, China was responsible for 52% of the growth in demand for basic chemicals and plastics.

     It seemed to some that this supercycle would run for many more years. But cycles, by definition, don't go on forever. In fact, IHS's nonenergy Materials Price Index reached its peak in April 2011, then began to decline. Since July 2014, that decline has turned into a rout, with the index falling 45%.

     Oil was the exception. Oil prices actually reached a peak of $115 a barrel in June 2014, when it appeared the Islamic State group might lay siege to Baghdad. But the Islamic State was stopped, and thereafter the underlying weakness in oil prices started to become apparent.

     The first reason for the dramatic price decline has been what has happened in the U.S. -- the shale revolution and the dramatic increase in the country's oil production. Little more than half a decade ago, the "peak oil" thesis was pervasive -- that the world was going to run out of oil, as well as natural gas. How the world has changed! A few months from now, the U.S. will begin to export liquefied natural gas and may begin to export crude oil.

     The breakthrough in shale -- hydraulic fracturing and horizontal drilling -- occurred more than a decade ago. It only became apparent with natural gas in 2008 and took a few more years with oil. But the impact proved enormous. Between 2008 and April 2015, U.S. oil output increased by 4.7 million barrels per day, which was almost a doubling. The increase was greater than the output of each of the OPEC countries except Saudi Arabia. The International Energy Agency made the startling prediction that within a few years the U.S. would overtake Saudi Arabia and Russia as the world's No. 1 oil producer.

     But this growth was, for a couple of years, offset by supply disruptions elsewhere, such as in Libya, and by the reduction in Iranian exports owing to sanctions. Yet by 2014, the relentless growth of U.S. supply was leading to a surplus in the world market.

     At the same time, the basic dynamic of the world economy was changing. IMF Managing Director Christine Lagarde captured it when she spoke about the "new mediocre" -- growth in the world economy was less than expected. In particular, China was slowing down, moving, as China's premier put it, from "high growth" to "medium high growth." That meant the accelerating growth in its demand for commodities was over.

     In the face of the surge in supply and weakness in demand for oil, Saudi Arabia and the Gulf countries made a historic decision last November. OPEC members decided not to cut production to support prices, reasoning that if they did they would only have to cut production again. Why, they argued, should their "low cost" oil "subsidize" the "high cost" oil elsewhere? They would only cut, they said, if everyone else did as well. And by that, they meant Russia in particular. The discussion still continues.

     It was expected that prices would fall, but the surprise was that prices fell much more than had been anticipated. The reason is that many analysts underestimated the resilience of U.S. shale production. This revolution, led by "independent" U.S. companies, is still unfolding with continuing innovation and productivity improvements.

     The IHS's Upstream Performance Evaluator allows us to examine the production characteristics of every oil well in the U.S. One key thing we have learned is the wide variability in shale oil wells. Some are big producers; some are marginal producers. In 2014, we discovered, just 30% of the new wells were responsible for 80% of the new production. In other words, there is great room to be more efficient. We expect that, by the end of this year, every dollar of spending on new wells will be 65% more efficient than was the case in 2014.

     This ability to be more efficient, to focus on the more productive opportunities, is why U.S. oil production has continued to increase in 2015, after the price collapse. Many companies were saying they could now be as successful at $65 a barrel as they had been at $100 a barrel.

     That is why oil prices have fallen further. U.S. oil prices in the $40 to $50 range are now putting a great deal of financial pressure on U.S. producers. As a result, we expect U.S. oil production to fall by about 10% from last April to next April. This will help to rebalance the market. The market will also be rebalanced over the next few years by the decisions oil companies are making to postpone and delay new projects -- or cancel them altogether.

     Yet, at the same time, if sanctions on Iran are lifted as a result of the nuclear deal, Iranian oil exports will probably begin increasing next spring. The 400,000 to 600,000 barrels a day that are expected would offset much of the anticipated decline in U.S. output and mean continued weakness for oil prices, at least in the first part of 2016.

     But the question remains: Why is cheaper oil not providing the big stimulus to the world economy that would have been expected? Until recently, it was assumed that "the reasonably strong U.S. economy" (as the head of the Boston Federal Reserve recently described it) was the bulwark of global growth. And we are seeing higher growth in demand for oil this year. According to our IHS Automotive data bases, SUV sales are now 56% of new vehicle sales in the U.S., compared to under 50% in 2012, which points to higher gasoline consumption. Moreover, motorists in the country are driving more miles. Yet the global demand response is not as large as a 50% drop in price would suggest.

     This gets to the basic question: Does the end of the commodities supercycle point to deeper problems in the world economy? Chinese economic growth has been a foundation for the world economy since 2004 and was the first source of rebound from the 2008 financial crisis. But China's economy is now slowing. How much is subject to much debate.

     It is not just a question of China's economy, as large as it now is, its heavy debt load and the signs of turbulence there. Rather it is the nexus of a slowing China and emerging market countries that have been so tied to Chinese growth. The signs are evident not only in lower commodity prices and collapsing economic growth (Brazil!) but in the fall of currencies, capital flight and high levels of emerging market debt.

     This specter caused a worried U.S. Federal Reserve to abruptly pull away from its expected course of action and not raise interest rates.

     In these circumstances, lower oil prices reflect the extraordinary buildup of a major new source of supply from the U.S.; they are also sending a more troubling message about the possibility of further weakness in the global economy.

Daniel Yergin

Daniel Yergin is Vice Chairman of the research firm IHS. He is author of "The Quest: Energy, Security, and the Remaking of the World Economy." 


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