Oil Price will settle at around $35/barrel

The price of Brent Crude has crossed $50/barrel, and it still has some way to fall. This is not a temporary short term drop in the price; it is the middle of a long-term price movement.There are huge reasons to think that the low price of oil is here to stay – at least for the next few years.

Analysts say that the Saudis are out to get the shale oil producers by keeping the oil price lower than their production costs. Sounds logical. But let’s take a look at the actual production prices.The production cost of oil shale is between $35 and $50/barrel – and this is the average production cost. But the bulk of the production cost is up front – when the well is being set up. The marginal production cost (i.e. the additional cost for prducing every additional barrel of oil) is lower – perhaps as low as $10/barrel. This means that shale oil wells that are already producing will continue producing as long as the oil price does not dip below $10/barrel. However, new wells will not be opened if the price of oil is less than $35/barrel (because investment decisions are made based on marginal production cost).

Offshore oil wells produce oil at $50/barrel. There are a lot of these wells in operation, e.g. in the Gulf south of the US. Their marginal cost of production is a mere $10/barrel, and will thus continue to produce inspite of the low price. However, it costs a lot to sink them ($40/barrel of the cost is from the exploration and development of wells). A price below $50/barrel will mean that new offshore wells will not be developed.

Oil from oil sands costs from $50 to $80/barrel to produce, and most of this is in everyday production cost. This means that this kind of oil will probably be frozen (figuratively and literally), if the price remains below $50/barrel. And there are other marginal producers, e.g. US small-scale drillers (e.g. producing less than 10 barrels/day) which may close down because production has stopped being profitable.

A price below $50/barrel means that offshore and shale oil will thus continue production in existing wells and even sink new wells. Specific economics will determine which wells will be sunk, and which will be deferred. As the price goes further below $50/barrel, fewer new wells will be started, and then not enough will go online to replace older wells that get depleted.

At the same time, oil continues to come from ‘traditional’ sources. Neither OPEC nor the other oil-producing countries are willing to reduce their production. Some are actually increasing production, e.g. Russia and Iraq; while some OPEC countries may also increase theirs e.g. Venezuela and Nigeria.

In the short term, the oil price will continue to drop because there is a lot more oil produced than is needed. The price will go even lower than $30/barrel. It will settle somewhere around $35/barrel.Below this point, it would not be profitable to open new shale oil wells.
In the next 3 to 5 years, the price will range between $30 and $40. After this, economic growth will push up the demand for oil to the point that the price will gradually rise again.

Looking Forward to 2015

Twice earlier, in 2008 and 2010, I wrote a blog with predictions for the year that had just started. Looking back, I didn’t do too bad. In fact, my only real mistake was predicting that Hillary Clinton would win the presidential elections in 2008.
I want to revive my practice of listing my predictions at the beginning of the year. I’m looking forward to reviewing them a year from now to see how well I did.

Philippines
Both Jejomar Binay’s and Mar Roxas’ stars will fade as presidential candidates. Someone else will take their place and go on to become the leading candidate for president.

The trial of Jinggoy Estrada, Juan Ponce Enrile and Bong Revilla will start, probably in the latter part of the year. Similarly, the long-awaited Ampatuan trial will also start.

In November or December, there will be a supertyphoon that will hit the country. It may be as powerful as Yolanda, but it will have less casualties.

The World
ISIL will no longer be growing. Both the area that it controls and the recruits that it makes will be much less than today. The entire Iraqi Kurd area (and maybe also the Syrian Kurd area) will be safe from ISIL.

Ukraine. Large areas of Donetsk and Luhansk provinces will be recovered from the rebels.

The ruble will drop to 100:$1 or lower. Russia’s GDP will decrease by 15% or more in 2015.

The oil price will hit $40/barrel, but will not remain at that price for long. It will adversely affect the economies of many oil producing countries. Notably, Russia, Venezuela and Nigeria. Even the US economy will be adversely affected.

The Greek Syriza party will not win the elections in February, meaning that Greece will not decide to leave the Eurozone.

Canada and the US will suffer extremely low termperatures for a large part of the winter. US economic growth in the first quarter of 2015 will suffer as a result.

High Oil Price?

The recent strike against high oil prices was not only unsuccessful, it was also futile. Because the government’s response was limited to two choices: either to leave things as they are, or decide to subsidize oil prices. There was no chance that the government could, or would, force oil companies to lower their prices. And I think that subsidizing oil prices is an entirely wrong thing for the government to do.

High International Prices
The price of oil products is indeed high. Compared to previous months, the prices of oil products have risen quite significantly. However, this is simply because of high international oil prices. The local oil companies may have prices than are a bit higher than they should be, but this would be because of inefficiency and not greed.

Oil prices in the Philippines, despite appearances, are in line with international prices. Filipinos point out to spot prices of $88/barrel, and ask why the price at the pump is similar to when the price was $130/barrel in 2007. Well, there are two reasons why this is so. First, the price of oil that the Philippines buys is based on the Dubai crude price, not on the West Texas Index of the US. Dubai crude price is similar to Brent crude at $112/barrel, while West Texas crude is $88/barrel (price of West Texas crude is 27% higher than Dubai crude). The second reason is that the quoted West Texas or Dubai prices are spot prices, i.e. they are the price for single shipments for immediate (within a month) delivery. Companies importing oil pay prices agreed to in long-term contracts (contracts of a year or more) where the price is lower. In 2007, the spot price may have reached $130/barrel, but long term contract prices were probably only half that. But now, with spot prices lower, the long-term contract price is only a few dollars lower than the spot price. It may be that the long-term contract prices now are higher than those of 2007.

A better approach to looking at prices is to compare the retail price of gasoline between countries. Retail prices would already include all costs that go into gasoline e.g. transport, refining, distribution, taxes etc. A ( comparison of international oil prices ) show that US prices are about $3.79/gallon, while that of the Philippines is $5.00/gallon (On 9 Sept, average price of gasoline was P55.95/liter ).  If we consider than the price of West Texas crude is 27% more than Dubai crude, the Philippine price should be $4.81. And if we consider that WTI is the price of crude oil already in the US, while in our case, the crude has to travel from the Middle East all the way to the Philippines, or price of $5.00/barrel sounds fair enough. The countries near us (e.g. Malaysia, Indonesia) which have lower retail gasoline prices subsidize them.

Better Response
Bayan Muna, Piston and other leftists would of course reject the above reasoning. They would point out that the oil companies are ripping off everybody. And in a sense, they have a point. But if this is so, then a strike in Manila would surely not be enough to reverse a policy that even manages to ‘rip off’ US consumers and consumers all over the world. The local oil companies that we have are not doing the big rip off. In fact, as we have shown above, they are probably ripping us off a lot less than their US-based counterparts are.

The government could still take meaningful steps against the high prices of petroleum products.  First of all, it could promote gasoline efficiency, by providing tax incentives for people to buy hybrid cars. Or by having centers that check and improve the efficiency of engines, for a discounted price. The efficiency of many tricycle  and jeepney engines could be significantly improved by relatively small changes to the engine.

Then, the  government could also initiate the process of raising jeepney, bus and taxi fares. Not that an increase should be done now, but that there will already be a decision to raise fares when diesel price exceeds a certain amount. So that drivers and operators of public utility vehicles don’t need to do the whole process when the price does increase.

There may also be a need for the government to closely monitor the books of the oil companies, to make sure that any lowering of costs are passed on properly to the consumers, and that price increases are truly based on real increases in costs, and not merely in anticipation of them.

Beyond the Debt Ceiling

The US is in the grip of the political drama around the raising of the debt ceiling. Economists are worried that if politicians fail to come up with a satisfactory solution, the US will go back into recession even if they finally agree on raising the debt ceiling.

Most Americans do not realize that solving the debt ceiling problem isn’t really the main issue. The main issue that they have to face is that the US economy is designed for the wrong century, and that it is long due for a transition to a more ‘modern’  design. Officials try to avoid the inevitable by artificially propping up the economy, but it won’t work. The transition will come. And it will be much more painful than a mere ‘double dip recession’ – it will make the recession of 2008 look like ‘foreplay’.

Transitions are alright in economics – the market will be able to recover and adjust the distribution of goods and services to adapt to any changes in the patterns of use. However, some transitions take long, and this means that the economy will suffer till the transition is over and the market has made the necessary adjustments.

The US is in the midst of three transitions: that of its housing patterns, the use of resources, and the US dollar. And since the nature of all these transitions is that they take a long time, I believe the US “crisis” will last for some time.

The government will naturally act as if it is only a matter of pushing through certain programs, and then the economy will recover. Perhaps certain programs may result in short term growth or increased employment. But this will ultimately be quite futile, and the longer term trends will overpower these gains.

 Housing
The economic crisis was caused by the housing bubble – specifically, the market for ‘sub-prime’ mortgages was oversold.  And this problem continues to this day, with homeowners continuing to default on mortgages. However, this is only part of the problem.  There is a creeping re-concentration of housing patterns in the US. People are not as willing as before to commute two hours or longer to work every day. This is partly due to the economic crisis – if you’re looking for a job, it is better to do so close to home. And, if your house is foreclosed, you would most likely move closer to the city for new and cheaper housing.

But the crisis only aggravates the problem, it did not cause it. Things like demographics (people getting older – and thus wanting to be nearer health care facilities) and the rising price of gasoline/diesel have a longer term effect on housing choices.

The movement of people from sprawling suburbs to smaller urban hubs means that many houses built in the suburbs will go unsold (or not rented) for a long time, and sometimes will only get sold at a very big discount. And the bad effect of this is that people won’t be that eager to buy houses in an area where house prices continue to go down. So, home building companies will lose money or even go bankrupt, until they completely shift their activities nearer urban hubs.

Expensive Resources
With the development of countries such as China and India (and of course, the rest of the world), there will be a squeeze to divide up all the resources needed. The days when Europe and America  could get away with using 80% of the world’s resources are over; and this means that the resources of the world should be shared more equally. And, this means that the price of most resources will go up significantly.

The resource that Americans  will really FEEL going up in price will be that of oil. From the crisis-level price of around $95/barrel, oil will surely go to $150/barrel by 2012. This is on the logic that if the world’s GDP returns to the pre-crisis level, so will the scarcity of oil, and this means that prices will return to pre-crisis levels. And that is only the beginning: beyond 2012, prices will rise even higher. Oil supply volatility may cause temporary peaks or dips in the price, but the overall trend is still for the price to rise.

For the American automobilist, this means that oil will return to highs of $5/gallon, or higher. This will need a permanent adjustment of living patterns. People will need to either commute less, ride trains or buses to work, or use smaller cars or hybrids.  And since oil is used for making things like plastics and fertilizers, the prices for these will also rise, forcing people to change their consumption patterns.

The rise in the price of grain, particularly that of corn, will eventually spell the end of feeding grain to cows.  At a certain point, the number of cows will be limited by the grass that they can eat. See High Corn Price Will Lead to Lower Beef Production Cheap meat will become a thing of the past.

Increased commodity prices will cause a move away from the throw-away economy. There will be a new emphasis on goods that last longer, and use less energy and other inputs.

The “Fall” of the US Dollar
The days of the US dollar as the international reserve currency are soon over. I would say that it would “fall” from this position sometime in this decade. And that the US economy will feel this change quite deeply. (see Two Years After the Fall )

The fall of the dollar finds its roots in the massive debts that the US has – almost 14.3 trillion dollars, to date. The Fed is even tried to stir up US inflation by ‘printing money’, or Quantitative Easing. And to make the problem worse, total US currency abroad totals $75 trillion.  The resulting inflation and the high amount of debt will be the dollar’s undoing; at a certain point, countries will decide NOT to keep dollars as reserve anymore, and NOT to buy up US treasuries, and this will drive up the interest rates on these treasuries.

Already, the rating agencies are threatening to downgrade the rating for US Treasuries from AAA to AA. While this seems like a small step, it will be the first push down the hill for the dollar.

The strength of the US Dollar rests on the willingness of other countries to keep dollars in their foreign currency reserves. Dollars make up to 80% of Central Bank reserves of many countries. Historically, this has meant that the US could buy more from other countries than it sells to them. If Central Banks’ change their mind regarding the desirability of the US dollar as a reserve currency (especially as a result of a change in Treasuries’ ratings), this will result in a sharp drop in the value of the US dollar. And  this point will happen sometime very soon.

After the Transition
After the decade of transition, the US will face a new period of sustained economic growth. The American people’s  flexibility and the country’s huge resources are sure bases for it to build a new prosperity.  Politicians should hurry the transition instead of trying to deny that it will happen.  They should not be distracted by the call to ‘preserve jobs’ or to ‘preserve our way of life’.

Two Years After the Fall

It is now March 13, 2014. America has undergone a huge shift in its economy in the last two years. On this day, in 2012, the dollar “fell” in value, by about 100%; and more importantly, it “fell” from its position as the world’s reserve economy.

The Dollar Falls
It all started in November 2011. Riots had broken out in Saudi Arabia, and the government was frantically trying to restore order. The Saudi government had bungled in its handling of a relatively small disturbance among Saudi Shiites in Qatif, in the Eastern province. In November 2011, the disturbance had escalated into a nationwide protest movement. By December, workers in the vital oil industry and in the ports had gone on strike. And the demands had hardened – where before they had merely asked for the release of arrested Shiite leaders, protesters had now gone on to demanding a Constitutional Monarchy, some even wanted a republic, while others were calling for the independence of the Eastern province. All of this caused the price of oil to go through the roof. By the end of December,  oil had reached $200/barrel.

To make matters worse, the US response to it was also wrong. Congress passed a new Stimulus Bill of $500 billion, and the Fed proclaimed QE4 – a program to pump $1 trillion into the economy, as a response to the new recession. Unlike what happened during the 2008 recession, however, the US was now alone in pursuing an expansionary policy. This caused a lot of misgivings in other countries regarding the value of the US dollar.

Oil producing countries responded by demanding that they be paid in “hard” currencies – e.g. Euro, Yen, even the Chinese Yuan – and NOT in US Dollars. By January 2012, Central Banks all over the world decided to cut the US dollar component of their reserves, by a modest 1/4. Thus, from an average of 80% of reserves in US dollars, to 60%. This seems to be a modest change in policy; but when it is done by ALL Central Banks at the same time, it had a devastating effect. This policy meant that the Central Banks would gradually replace their dollars with other currencies in the course of a number of months, eventually ending with the target percentage of US dollars in reserve. By the end of February, however, the value of the US Dollar had gone down to the point where Central Banks holding lots of dollars (mostly in the form of US Treasury Notes) became nervous. They stood to lose a lot, if the dollar lost value.

So, it finally came on Tuesday, March 13, 2012. The Saudis were the first to dump their US dollar holdings. This was followed by Russia, Japan, and then China. After this, everybody else dumped their dollar holdings. You could probably speak of an “oversold” situation with the dollar then, but Central Bankers didn’t care anymore – they just wanted out, as quickly as possible.  As a result of all this, the dollar sunk to $4: 1 Euro on March 16, 2012. In the months following, the dollar regained some strength, finally stabilizing at $3:1Euro by December 2012.

Picking up the Pieces
The US was left to pick up the pieces. It still had a big budget deficit, and a huge payments deficit, and a 16 trillion national debt. The only good news in all this was that the national debt remained at 16 trillion dollars, even though the dollar was half its former value (thus, effectively the national debt was reduced by half).

The US had to go to the IMF to borrow money to finance its budget deficit. Nobody else was willing to lend the US money at that time. The US got a 500 billion SDR loan from the IMF (roughly equivalent to $500 billion at the old exchange rate). But the IMF loan came at a price: the US government had to cut spending, and increase taxes, and it had to have a concrete program to balance the budget by 2015. The US also had to open up its economy to foreign investments (thus, the airline, oil, banking etc. industries were opened to 100% foreign ownership).

Recovery
The IMF conditions were tough, but now, 2 years after the fall, the economy is on its way to recovery. US labor costs had dropped in relation to the rest of the world (while the US dollar’s value was halved, prices rose 30% and wages rose only 10%). This has led to a huge expansion in US-based manufacturing of products which used to be imported from China. (Another large chunk of the production had gone to Mexico, from which it is cheaper to ship to the US.) Automobile production has greatly expanded, with so many people buying smaller cars, hybrids and EVs (Electric Vehicles). And there is now a huge demand for buses, as local governments expand their public transportation services.

Tourism is now booming, with Asians and Europeans making the most of  “cheap” US vacations – tourism revenues have quadrupled since 2012. There is also a surge of “medical tourism”, with Europeans and Asians coming for elective surgery (which are not covered by their country’s health insurance).

American university enrollment has surged; while the number of American students has lessened, foreign students have more than made up the loss. Foreigners find that the US is offering quality education at bargain prices. And while foreign graduates are now in demand in the US, a bigger percentage of them opt to work in their home countries about graduation.

The stock market is enjoying a bull market of sorts – the Dow Jones just topped 20,000 points last January. Some companies are having a hard time: Walmart’s sales suffered as a result both of the lower purchasing capacity of people and the higher prices of goods. It is now repositioning stores to city centers, since people now find their suburban locations “too far away” (due to high gasoline costs). Starbucks has suffered because people have decided en masse that Starbuck’s coffee is a “luxury that they could live without”. Airlines are suffering from people cutting back on air travel.

But more companies are thriving: McDonalds has noted an increase in sales, even in the face of 30% higher prices; Amazon has seen a boom in the sale of Kindles and e-books (paper prices have also spiked); IT companies are profiting from people spending more time at home (people are also working more from home).

People have developed new habits. The magnetron is still all important; what’s new is that companies are now selling magnetron meals in reusable containers. Children often go to school now on bikes (leading to a reduction in child obesity). People are consuming more (local) vegetables, and eating less meat.

Many more people are employed than at any time in the past few decades. The unemployment rate is now at 5%, and is still dropping. There are less illegal Latinos now, since many Mexicans now prefer to work in the new Mexican factories. Americans are now more willing to take on farm jobs that were formerly done by Latino migrants. There is a marked reduction in the drug trade, with lower US buying power and prosperous Mexican workers.

There are now plans to build a nationwide rapid rail network. Ordinary rail lines are more intensively used for carrying products (replacing trucks), and a lot more products are transported by water. Solar farms are being set up in the Southwest; in Hawaii, the government is feverishly building solar and wind power plants (Hawaii was the worst hit by the oil price rise).

The “fall” of the dollar has caused a lot of suffering in America. But the American people are not only adapting well to the change, they are actually thriving. The resilience and hard work of the American people is now showing that a new economy could be fairer, greener, more equal, and eventually, more prosperous.

Some people say that the “fall” may have been the best thing to happen to America. They’re probably right. The future indeed looks quite bright.