It’s hard to believe today that in the summer of 2014, not even two whole years ago, that the price of a barrel of Brent crude oil sat at $115. Today crude prices touched a decade low $32 a barrel. What a difference a year and half can make.
To gauge the effects of price on the global economy, it’s helpful to understand how we got here. Three big factors came together to drive oil prices down: The first was the strong dollar, which has been on a tear against other world currencies since 2013. Since commodity trades are denominated in dollars, the strong dollar put downward pressure on all commodity prices, including oil, gold, copper, silver, steel and virtually everything that comes out of or is grown in the ground.
The strong dollar got the price ball rolling downhill but other factors conspired to accelerate the downward trend. The Chinese economy hit a soft spot and China reduced its use of oil. Normally the market reacts to an increase in supply by scaling back production but OPEC, the world’s largest oil producer, did not want to scale back production and the oversupply soon became a glut and prices cratered. Right about the same time the oversupply kicked in, the amount of domestic oil production in the United States really started to pick up, largely due to hydraulic fracturing and tar sands extraction.
Also about this time, the world made a deal with Iran to lift the economic sanctions in exchange for them dropping their nuclear ambitions. Iran and Saudi Arabia are both religious and sectarian enemies and Saudi Arabia saw low oil prices as a way to hurt Iran.
How low can oil prices go? Some analysts believe $20 a barrel oil is not out of the picture sometime in 2016.
Liquidity Dries Up
Many countries depend on oil to fuel their economies, including Mexico, Venezuela, Brazil and Russia. Without the flow of oil dollars, the financial position of oil dependent countries has become precarious. Venezuela was reduced to trading oil for paper products and the effect has been brutal on the Russian currency, the ruble. In the new connected global economy that is a huge drag on growth, ironically exacerbating the oil supply problem.
With oil prices this low oil companies can’t afford to spend a lot exploring for new sources and, with supplies this high, there’s no real point stretching to pull more oil out of the ground. Oil companies will quickly curtail their efforts to locate and extract new deposits. Most of the projects producing new oil today were started when oil was $100 a barrel. At $30 a barrel no one in their right mind would fund a new oil extraction plant.
Defaults and Layoffs Ahead
So far U.S. oil producers have been tenacious hanging in there but that can’t last. If prices continue to fall and stay low, we’ll see a raft of oil company defaults. The oil industry has already been blasted by layoffs, which could result in negative job growth numbers for Texas; North Dakota's in the same boat. Oil company defaults will create new pools of unemployed with a very specific set of skills that are not widely in demand. These aren’t just unemployed people, they’re potentially the long-term unemployed.
When the gas pump says $2/gallon, it’s easy for consumers to forget how fast that price can change. Few today remember the devastating effect of the Arab Oil Embargo of the 1970s, but anyone who lived through it remembers how bad it was in those days. We could be setting ourselves up all over again for another 1970s style fuel shock. Remember, it only took us eighteen months to get to $2/gallon gasoline.