The good, the bad and the superb of cheap oil

The dramatic collapse of oil prices at the end of last year caught most by surprise.

The dramatic collapse of oil prices at the end of last year caught most by surprise.

For three-and-a-half years, between February 2011 and August 2014, Brent crude oil traded in a stable price range, averaging about $110 a barrel.

Investors, producers and consumers came to accept that $100 a barrel was an appropriate price for planning purposes.

As recently as June 19 2014, Brent closed at $114.94. But then prices began to fall increasingly rapidly until, this month, oil fell below $50 (about R570) a barrel.

In retrospect, the sequence of events which precipitated the collapse has a compelling logic, namely, the interaction of two significant developments: a technical revolution in the production of oil, and the economic slowdown in emerging markets, especially China.

Fracking revolution

Historically, almost all oil production has come from porous rocks, which allow oil to drain into subterranean reservoirs. Oil exploration involves finding those reservoirs, and oil production involves drilling to extract their contents.

But large amounts of oil and gas are also trapped in less-porous shales. Fracking is the technical game changer: it allows these previously inaccessible resources to be profitably exploited. The US enjoys a combination of factors that have allowed this new technology to be deployed at astonishing speed: an abundance of entrepreneurial initiative; mineral rights in private ownership; a well-developed petroleum infrastructure, and a favourable tax regime.

Prior to 2008, there was much talk about "peak oil", the view that, as a consequence of resource depletion, it would no longer be possible to increase oil production significantly.

Thanks to fracking, US oil production, which had been in decline for many years, started to increase in 2009. This has led to growth in overall global oil production - silencing the proponents of peak oil.

Emerging-market slowdown

As a general rule it is always a slowdown in demand which precipitates a price collapse - and recent events in the oil market are no exception.

Initially, rising production in the US was easily absorbed by growing demand in emerging markets. Indeed, the fact that the price remained above $100 a barrel for so long is evidence that the oil industry was finding it difficult to meet the needs of rapidly growing economies.

Growth in China, India and Brazil accounted for most of the increase in demand, despite the fact that consumption in the developed economies declined.

But in the past two years, the great emerging-market boom has come to an end, as the growth rates of these economies fell. In particular, Chinese expansion has slowed.

The great surge in investment, which created the biggest commodity boom yet seen, is abating as commodity prices fall. Oil held up for longer than other commodities, but it, too, is suffering the consequences of a drop in demand - at a time when supply is increasing.

A price collapse became inevitable.

So what happens next?

There is an adage in commodity markets that what ends high prices is high prices, and what ends low prices is low prices.

In response to changing circumstances, producers and consumers change their behaviour. But history teaches us that this can take more than five years for most metals and minerals. Oil is probably an exception to the rule, and the impact of low prices will manifest sooner.

Oil differs from other commodities, both in terms of the investment needed to sustain production and the weighting of production costs towards exploration and development. The cost of actually pumping the oil from the ground, refining and delivering it to consumers is just a small part of the entire cost.

The oil industry is still profitable at $50 a barrel. So, the recent decline will initially have little impact on production.

But the average operating life of oil wells tends to be relatively short. Without investment in new wells, production will drop.

Lower oil prices have caused a devastating drop in cash flows, which oil companies use for new investment. A $50 decline in the price knocks $1.6-trillion off industry revenues. Companies will have no choice but to severely curtail investment.

Sustained oil production requires a price significantly higher than $50 a barrel - probably more like $80.

So, if prices remain where they are, production will start to decline within two years. Over the longer term, current oil prices are not sustainable.

The impact of low oil prices on the world economy

The $1.6-trillion loss in revenue for producers is at least matched by an equal gain for consumers. Theoretically, price changes are just a transfer of cash from one group to another.

In the case of oil, this relationship is more asymmetrical, because there is a tendency by oil-producing countries to accumulate their profits as foreign exchange reserves or in sovereign wealth funds.

For this reason, perhaps counter-intuitively, high oil prices tend to have a deflationary impact on an economy. This is because, when prices fall, producing countries draw on these reserves to maintain their living standards. So a fall in oil prices should have a stimulatory effect on consumption of other goods.

This will more than compensate for declining investment in the oil sector, possible defaults by countries such as Venezuela and Russia and the bankruptcy of highly indebted oil firms.

The winners in this scenario are the significant importers such as Europe, Japan and India. Given that these regions are economically depressed, lower oil prices will act as a stimulus to world growth in 2015.

South Africa is among the beneficiaries. This country imports about 150 million barrels of oil annually, so a $50 reduction in price at an exchange rate of R11/$ is worth R82-billion - or about 2.2% of GDP.

Consumers are already benefiting from a significant reduction in petrol prices. A lower import bill for oil will compensate, to a certain extent, for the decline in prices of South Africa's mineral exports.

Low oil prices might not be sustainable in the long term, but the prospects for 2015 are looking more favourable already.

McGregor is a portfolio manager at Allan Gray