Why weaker Chinese growth poses global oil price dilemma

Over a decade ago a surprise overheat of the Chinese economy drove oil prices to unprecedented highs that at one point peaked at $147 per barrel.

The recent slowdown of the Chinese economy is among key factors that are contributing to oil prices staying below $50.

In 2005 China consumed 6.9 million barrels per day (bpd) of oil, increasing to 11.1 million bpd in 2014 which represents about 12 per cent of total global demand.

The global oil supply/demand balance and prices will continue to be impacted by the Chinese economy for many years to come. Many oil producers still have their eyes on China for their incremental oil exports.

For reasons other than the Chinese economy, the world has been awash with crude oil overproduction which since last year has kept prices down. The current reduction of Chinese oil consumption has only made an already oversupplied situation worse.

But are oil prices below $50 sustainable? Many oil experts argue that recurrent prices cannot support or guarantee stable oil supplies.

This is because much of the oil production cannot break even at these prices. And many oil-exports dependent nations can no longer sustain their national budgets at prices below $50.

Even Saudi Arabia with its cash surplus can survive low prices only for so long before the country comes under budgetary stress.

Decision

The “not-unanimous” decision by Opec members in November last year to let production and prices find their own market levels is already creating divisions and tensions among the 12 members.

The Opec controls about one third of global oil production. Saudi Arabia and its immediate Gulf neighbours (Kuwait, Qatar and UAE) support market-determined production and prices.

The “budget-stressed” members like Algeria, Nigeria, Angola, Venezuela and Ecuador are pushing for production control to force up the prices.

The other group of three countries (Iran, Iraq and Libya) has been in situations of political conflict and are planning for increased “catch-up” production to their historical potential.

Specifically if Iran lives up to its intentions when the nuclear related sanctions are finally lifted, then we can see much more oil in the already flooded market.

Of all oil producers, it is only the Opec group which has an existing forum that can collectively discuss production and prices, and this they have done since the early 1970s.

But Opec is not always a homogeneous group as members have their own individual national agendas to push. It is only when members sense a very serious “common threat” do they adopt and fully implement unanimous production control decisions. Continued oil prices below $50 may be that trigger.

But Opec sees the new US non-conventional oil from shale as the “intruder” volume which is upsetting the global production/demand balance. Will the Opec readily agree to cut production if the US continues to increase theirs? And this is the real genesis of today’s oil production politics.

The US, with its “anti-trust” laws, will normally not engage in group or bilateral discussions in respect of global market sharing or price fixing.

The US shale oil producers are businesses independent of the government and will therefore produce as much as their returns dictate. When they hit the profitability limit then their production will tail off. Again, at prices below $50, this scenario is not very far away.

The Russians who have surprisingly maintained their production levels may also be hitting the limit of their political or economic resilience as prices remain low.

Russia appears very likely to support the Opec production control idea. Saudi Arabia, US and Russia each produces about 10 billion barrels per day, which in total amounts to about one-third global production.

Whichever way one of them plays the production game, prices can either go up or remain low.

The oil industry remains in a dilemma. On the demand side, global oil consumption demand is certainly weakening especially with the recent Chinese experiences. Green efforts especially in developed countries continue to weaken oil demands.

Although developing countries are consuming more (thanks to low prices), the increase may not be large enough to countermand demand decreases in the developed world.

Output

On the supply side, producers are apparently planning on stretching their oil production to the last economic barrel to maintain existing producing assets, pay off debts, and balance their national budgets. So when does the supply/demand equilibrium arrive, and at what price levels?

The answer to this question is what has continuously eluded many oil economists who find it difficult to meaningfully predict future prices.

At the current low prices, sufficient investments to guarantee future supplies are not happening. Investments not undertaken or delayed now will mean less oil in about five years time.

If demands will have irretrievably reduced, then there will be no cause for alarm. But if investments and production substantially lag behind demands, then we shall be back to where we were 19 years ago and prices will rise sharply. And the predictable cycle shall have started all over again.

Not reducing production immediately (by whomever) is self-destructing for the entire industry’s sustainable survival as investments will remain starved.

There appears to be general acceptance that if oil production is “correctly” reduced, a price range of $70-80 can ensue and this can re-establish sustainability in the oil industry.

Mr Wachira is director,Petroleum Focus Consultants, [email protected]