By W.A. Wijewardena –

A drastic reduction in crude oil prices

Crude oil prices in the world market have tumbled and they are still tumbling. The average price of the West Texas Intermediate category of crude oil stood at a level of $ 100 per barrel, which is equal to 159 litres a few months ago. It has now fallen to a level of $ 60 per barrel last week. This is practically a decline of 40% in an important commodity within a few months.

Supply has grown faster than demand causing prices to fall.

The price of any commodity falls mainly due to that commodity having an excess supply. An excess supply can occur due to a fall in demand or an increase in supply or both. In the present situation, when the Northern Hemisphere of the globe goes into winter, the demand for oil products normally rises because of the need for heating. Hence, if there is an excess supply this winter, it is mainly due to the supply of crude oil rising faster than the increase in demand.

Two theories have been raised to explain the current excess supply of crude oil in the market. One is economic and the other is political.

The US going into tapping shale oil resources

The economic reasons are less unknown in this part of the world. That is, the United States has, in a big way, explored oil in new oilfields known as ‘shale oil’ fields by using a new technology called ‘fracking’ which is the shortened form of what is ordinarily called ‘fracturing’.

Oil shale refers to a rock situated about 4-5 km beneath the surface of the earth containing solid bituminous materials called kerogen that are released as petroleum-like liquids by heating the rocks (available here) The shale oil is in solid form and therefore cannot be pumped to the ground like the oil that is extracted from conventional oil fields. Hence, even though the availability of oil in shale rocks was known for centuries, the commercial exploitation of shale oil did not take place until the early part of the second decade of the new millennium.

Even as late as 2011, the US Bureau of Land Management had concluded that “there are no economically-viable ways yet known to extract and process shale oil for commercial purposes.”

The fracking technology to bring shale oil up

But this was not to be for long. A new method of tapping the vast deposits of oil and gas contained in shale rocks was used on a commercial basis in the US after around 2012. That was called hydraulic fracturing or simply ‘fracking’.

With this method, what is being done is that a vertical hole is drilled up to the formation of shale rocks, which are located about 4 km below the ground level. This vertical drill is continued horizontally through the shale rock similar to the ‘donas’ which one finds in gem pits in Ratnapura. Then, about 4 million litres of water mixed with sand and chemicals are injected at high pressure to the horizontal section of the drill causing the shale rock to fracture and crack open, similar to the fracturing which may happen in a bone of the body when it is subjected to a heavy blow.

The fissures created by the fracturing are kept open by the sand that is released along with the water mixture. It causes the shale rock to release the gas and oil which had been contained within it for many millions of years. The oil and gas mixed with water are then pumped back to the ground, separated and used for further processing. The recovered water is first stored in open pits and then removed to treatment plants.

The fracking revolution

Fracking has revolutionised oil and gas exploration in the world. This was hitherto a commercially untapped resource and now it is being tapped on a massive scale, especially in the northern part of the United States.

Its sudden proliferation has helped the United States to boost production of both these energy items. By 2014, the US became self-sufficient in natural gas and in the case of oil, emerged as the world’s largest producer of crude oil, driving Saudi Arabia down to second place.

It is estimated that by 2020 the US will become self-sufficient in crude oil as well. This was good news for Obama administration which had been beleaguered by all for a lack of visible economic recovery in the country. Hence, despite the protests against fracking on environmental grounds, the Obama administration is openly supporting the new oil exploration venture which US companies have undertaken.

The world’s fracking mania

Shale oil is not confined only to the US. It is abundantly available in the southern provinces of Canada, Lithuania, China and New Zealand. After it was proved that fracking technology was a commercial success, all these countries have now started plans to exploit their shale oil resources. The increased oil and gas production in the US has reduced its imports creating a glut in the current energy market, sending prices down.

Planned future shale oil exploration by other countries will keep the market glut going for many more years. The current surplus as well as the expected surplus has sent oil prices tumbling in the world market. That is the economic reason for the present decline in oil prices.

A conspiracy theory to explain falling oil prices

The political reason is associated with a popular ‘conspiracy theory’. The present glut has been augmented by Saudi Arabia’s refusal to cut oil production to match the reduced import demand to maintain oil prices at its historical average of $ 100 a barrel.

The Saudis have rationalised that even if oil prices have come down to $ 40 a barrel, they would still not consider cutting oil production. The present low oil prices are a loss to Saudis and other members of the Organisation for Petroleum Exporting Countries, popularly known as OPEC. But if prices further tumble to a $ 40 level, their losses would be augmented beyond recovery.

In this background, what has prompted the Saudis to stubbornly refuse to cut oil production? The conspiracy theory has been harboured to justify this irrational behaviour.

Bringing Russia to its knees

It has been argued that the Saudis want to punish three parties by allowing oil prices to fall in the market. First, it is to punish Russia which is supporting the Assad regime in Syria which the Saudis want to topple. Russia is heavily dependent on its oil resources for financing the budget and earning foreign exchange. About a half of its budgetary revenue and about 60% of its export earnings come from the oil sector. When these earnings dwindle on top of the present economic sanctions against Russia by the US and the EU on account of its expansionary policy toward Ukraine, Russia is expected to fall to its knees, fully appreciating the emerging stark economic realities.

Already Russia has been punished by these two counts: its currency, the rouble, has fallen in the market from around 30 roubles a dollar to 70 roubles a dollar. The Russian Central Bank is desperately trying to keep the rouble from further falling by releasing some of the dollar reserves it is holding and increasing interest rates to an unprecedentedly high level of 17% per annum. Both these measures are expected to punish Russia in the long run by shrinking its economy.

Punishing Iran for having nuclear ambitions

The second party which it is claimed that the Saudis want to punish is the unfriendly regime in Iran. Iran’s nuclear ambitions have been considered by the Saudis as a threat to their existence. Since it is unlikely that Western sanctions against Iran could force the regime to abandon its nuclear ambitions, it is said that the Saudis want to make their own attempt. That is, by forcing oil prices to fall in the market and maintaining them at those low levels for sometime the Saudis want to deliver a fatal blow to that country.

Damn the US shale producers

The third party to be punished, according to this conspiracy theory, are the shale oil manufacturers in the US. Tapping shale oil resources is a costly affair and if oil prices fall below $ 80 per barrel, given the current cost structure, the boom in the shale oil sector in the US will come to a sudden end. Thus, it is alleged that the Saudis want to eliminate one of their rivals who has resorted to alternative oil exploration.

Can the Saudis be on a self-destructive path?

This conspiracy theory is rationalised by pointing to the low cost of the production of crude oil in Saudi Arabia. Since Saudi oil is found pretty close to the surface level, it is blessed with the lowest cost among all the oil producers in the world.

Its costs range between $ 15 and $ 25 per barrel whereas in all other countries they are above 50 per barrel. So, the Saudis can still survive even at a price of $ 40 per barrel whereas all other producers, including the US’s shale oil producers, will vanish from the market at that price level.

It is economics and not conspiracies which rules markets

Many believe in this conspiracy theory because it is exciting and appealing to the popular sentiments of people. It is the big and powerful guys who are to be punished and not the poor nations in the world. Hence, a conspiracy theory which suggests that the US is going to be punished has much more appeal than any other conspiracy theory.

But if this conspiracy theory is true, then, the Saudis are on a self-destruction path. Saudi Arabia depends principally on its oil sector for wealth, export earnings and prosperity. If oil prices are at a low level for a significant period of time, it is Saudi Arabia which is to suffer more than those countries which it wants to punish. Further, though the Saudis can withstand and survive through a price reduction, all other members of OPEC cannot do so due to the high cost of oil production by them. Many such producers, especially Venezuela and Nigeria, have to close shop if they are hit by such an external oil price shock.

It is therefore unlikely that any rational decision-maker would go for such a self-destructive choice. Hence, it is more likely that these punishments are simply a natural consequence of the present global oversupply in oil rather than deliberate action taken by one of the leading oil producers.

Market’s reaction to low oil prices

Thus, the natural market forces will do a series of market adjustments to correct the current fall in oil prices. Pressure would be exerted on Saudi Arabia to cut output and thereby bring oil prices up again. Investors in shale oil in the US, finding that their oil wells are no more economical, will voluntarily restrict oil production thereby permitting oil imports to the US once again.

Those countries which are blessed with shale oil deposits will postpone their plans to tap this resource thereby taking out the expected market supply of crude oil due to new shale oil exploration. Accordingly, market prices will start moving up once again and get stabilised at around $ 80 to $ 90 per barrel. That price is an economic price for all other oil producers in the world.

Low oil prices are an inhibiter to Sri Lanka’s Mannar Basis ambitions

Sri Lanka’s current oil consumption stands at about 1 billion litres of petrol and 2 billion litres of diesel per annum. It would have gained a significant benefit due to the low oil prices had it not increased its vehicle imports in a large measure in the recent past through a supporting duty reduction.

Vehicle registrations are increasing at a rate demanding more oil and diesel imports. Accordingly, though the price is low, the volume will increase, reducing the total benefit which the country would have gotten out of the decline in oil prices in the world market.

Sri Lanka’s nascent oil exploration efforts in the Mannar Basin will also suffer if oil prices are at a level of $ 80 or below. These offshore oil explorations are such a costly affair, even North Sea oil producers cannot survive unless oil prices have risen to a level of $ 90 and above.

If the prices are lower than this threshold price, the Mannar Basin oil could be pumped up only with a supporting subsidy by the Government. Hence, it will be more economical for Sri Lanka to keep the oil under the sea level in the Mannar Basin instead of taking it out.

The current price fall is a temporary phenomenon

Therefore according to economic logic, the current tumble of oil prices in the world markets is going to be a temporary phenomenon. They will remain at these low levels only for another six to eight months. After that, prices will settle once again at a level of around $ 80- $ 90 a barrel.

*W.A Wijewardena, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at waw1949@gmail.com