1. Energy Academic Group Seminar February 20, The Causes and Consequences of The Oil Price Decline Dr. Robert Looney, NSA
Federal Reserve Bank of Chicago, Strong Dollar Weak Dollar

2. Future Oil Prices
Many analysts feel movements in future oil prices are likely to be influenced by several key factors:
Future supply/demand conditions
OPEC strength/objectives
Geopolitical factors
Movements in demand
As a general rule, lower oil prices today, by reducing investment, result in higher prices in the future
Key question – how has shale modified this relationship?

3. Future Supply Conditions I
How persistent is the supply shift likely to be?
Depends on two factors
First is whether OPEC and in particular Saudi Arabia will be willing to cut production in the future
This depends in part on the motives behind the change in its strategy and the relative importance of geopolitical and economic factors in that decision.
One hypothesis is that Saudi Arabia has found it too costly, in the face of steady increases in non-OPEC supply, to be the swing producer and maintain a high price – other countries free ride at Saudi expense
If so, and unless the pain of lower revenues leads other OPEC producers and Russia to agree to share cuts in the future – strategy unlikely to change in the near term.

4. Future Supply Conditions II
A related hypothesis is that it may be an attempt by the Saudis to reduce profits, investment, and eventually supply by non-OPEC suppliers, and even OPEC suppliers
Some of whom face much higher costs of extraction than the Saudis
The Second Factor is how investment and in turn oil production will respond to low oil prices.
Exploration and production budgets for 2015 face significant curtailment
Major projects in high-cost oil basins will be cancelled or postponed
However the time lag between investment and production means that additions to supply will continue to come on stream for some time
Many projects are simply too far ahead to be stopped

5. Future Supply Conditions IV
For unconventional oil such as shale (which now accounts for 4 million out of a world supply of 93 million barrels a day):
The break even prices – the price at which it becomes worthwhile to extract in the U.S. are typically around $60 per barrel
However a new analysis based on individual well data finds that 80% of new tight-oil production in 2015 would be economical between $50 and $69 a barrel
Companies will continue to improve technology and drive costs down.
Still with prices near or below $60 a barrel, U.S. companies are looking hard at their investment plans – where and how much to cut or postpone.
But it will take time for these decisions to affect supply
U.S. output will continue to rise in 2015

6. Future Supply Conditions V
Break-Even Prices for U.S. Shale basins
Lower Oil Prices Are Putting the Freeze on Fracking Projects Around the World Business Insider December 8, 2014

7. OPEC I An effective cartel requires three things: OPEC lacks all three
Discipline
A dominant market position, and
Barriers to entry
OPEC lacks all three
Its members cheat on quotas,
It supplies only 30% of the world’s oil – too little to exercise control and
New producers abound
OPEC more follows the a dominant firm model than a cartel
Saudi Arabia its most influential member could have sent the price up simply by deciding to pump less
The Kingdom has savings of $900 billion
Economist

8. OPEC II But Saudi Arabia can also weather a low price
Its production costs are $5-$6 a barrel – the lowest in the world
History suggests most of the gains from any cut in its output would go to other producers who would sell their oil for more while increasing their market share
Saudi Arabia did try this tactic in the early 1980s cutting its output drastically
Result -- higher prices but also a boom in investment and then production in places like Britain and Norway
Trying to save OPEC with such tactics could be even more dangerous now
Cheap oil has its consolations for Saudi Arabia
Russia and Iran two countries which the Saudis have differences are hurt much more

9. Likely Future Prices I
Likely developments regarding future supplies, and OPEC strength impacting on future prices suggest little upwards pressure.
This is also the market interpretation -- futures markets now show an expected recovery of prices into 2016
However, uncertainty comes not only from supply, but also geopolitical and demand factors
Geopolitical Factors
geopolitical tensions in Libya, Iraq, Ukraine and Russia should not be underestimated
Demand Factors
High uncertainty about global economic activity, especially in the Eurozone and China, and thus the derived demand for oil
Not much optimism now for rapid global expansion.

10. Likely Future Prices II
Short Run Oil Price Movements
Currently the oil market is massively oversupplied
Unless OPEC acts as a swing supplier a glutted market is highly unlikely to be avoided given the lags involved in curbing production.
Some supply curtailment is already evident in early 2015 especially in U.S. shale
However there will be a substantial inventory overhang through most of 2015
Demand for oil should increase somewhat given lower prices and by early 2018 demand and supply should once again be in balance.

11. Future Prices V Several factors might modify this outlook
Key downside risk
instability in Eurozone results in many countries falling into recession
Key upside risks are
an acceleration in demand particularly with China topping up its strategic reserves, or
A supply disruption sparked by geopolitical frictions,
Baring these, oil prices should reach approximately $65-70 in 2018.

12. U.S. Energy Security I Implications for U.S. energy security
We define energy security as the ability of households, businesses and government/military to effectively manage disruptions in energy supply.
Traditionally low prices have been looked on as reducing energy security because they
Undermine incentives for investments in energy expansion and efficiency
May remove sources of revenue that deter investors from upgrading or expanding energy infrastructure that that could enhance the reliability of the energy system.
Countering these two tendencies are
The prospect of rising prices beginning in the first part of and,
Developments in global markets that may have fundamentally altered the economics of oil

13. Energy Security II How will U.S. energy security be affected?
With the good prospect of markets firming up again in 2017, whatever loss in energy security has occurred because of the oil price decline, should be quickly reversed.
In addition the period of low prices are unlikely to have an adverse effect on alternative renewable energy supplies
The period of low oil prices has demonstrated the weakness of OPEC.
That organization unlikely to play a major role in the future in constraining energy supplies

14. U.S. Energy Security III
Most importantly the oil price drop demonstrated that there is a new economics of oil
In the past, new supplies of oil had come from large expensive fields with a long lag between price increases and subsequent follow on investment
Today, a shale-oil well can be drilled in as little as a week and at a fraction of the cost of conventional oil
Process is a little like manufacturing drinks – whenever the world is thirsty, you crank up the bottling plant.
Shale development should reduce volatility in oil markets while providing the world and the U.S. with diversified sources of oil – both enhancing energy security

15. U.S. Energy Security IV
In addition there appears to be underway a shift in conventional oil production
away from unstable higher cost sources --- Venezuela, Russia, Nigeria, and Iran
toward more secure lower cost locations -- specifically the GCC
The GCC is determined to maintain market share and to do this they are expanding productive capacity and will likely hold the price lower than in the past to accomplish this – in effect replacing OPEC
Their output will come at the expense of higher cost countries
Saudi Arabia has sustainable oil production capacity of 12 million b/d
Kuwait is investing in sustainable capacity of 4 million b/d and Abu Dhabi going for 3.5 mill b/d
Shift to opec from o’ Sullivan

16. U.S. Energy Security V
By 2020 the six GCC states could be in the position to produce 21 million b/d
Why Should the GCC countries change their strategy?
Markets since 1973/74 have allowed the GCC OPEC states to meet global demand at times of supply interruptions elsewhere and to adjust exports to meet OPEC price targets
Supply risks remain but they are much lower. Consuming countries have
Increased strategic reserves
Diversified away from potentially unreliable oil and gas sources
Boosted domestic energy production and
Promoted renewables

17. U.S. Energy Security VI
There are good reasons for the GCC to radically raise production and exports
We are entering an era where production efficiency rather than control of reserves will be decisive
Neither Saudi Arabia nor OPEC will be able to prevent a secular and structural decline in energy prices
If the GCC wants to maintain its oil and gas income, it will have to increase hydrocarbon exports
Lower prices in turn will weaken three U.S. adversaries Russia, Iran and Venezuela

18. U.S. Energy Security VII
If Saudi Arabia and the GCC lift production as much as possible US-GCC combined production will exceed 30 million b/d by 2020.
This is a figure higher than OPEC’s 2014 production and would be equivalent to about 30% of forecast world demand for that year.
It would be enough to ensure the GCC working with the US for a generation and more will be able to shape the structure and direction of global energy
These oil price trends and associated developments should considerably enhance U.S. energy security.