Wednesday, January 14, 2015

Kissed by a rainbow. The good news on oil prices we didn't see coming

How'd we get so lucky? The price of oil halved in a matter of months and hardly any of us saw it coming.

Back in September when the oil price was $US93 per barrel Australia's Bureau of Resource and Energy Economics forecast "a gradual decline" to a figure still north of $US90. What happened was a collapse to $US46.

If it stays near $US50 (and there's talk or $US40 or less for two or three years) the typical Australian family will save $14 a per week according to the AMP's Shane Oliver.

He bases his calculation on an average petrol price of $1.13 per litre (it's already fallen to to 99.9 cents in some places) and an average top up per week of 35 litres.

Put in perspective, $14 per week is more than the benefit per family from another cut in mortgage rates. It's around $730 per year, worth as much as a pay rise of $1100 to someone on the typical tax rate.

There's every reason to believe families will spend some of it, giving businesses the confidence to put on more workers.

Not only will the new much lower oil price boost the economy directly, but by cutting inflation to as little as 2 per cent (that's what's expected when the next figure comes out) it'll give the Reserve Bank more than enough room to cut interest rates as well if it wants to do more.

It's like the sudden emergence of the resources boom all over again, except that where that showered Australia with income, the halving of the oil price will slash costs, for businesses as well as consumers. The mining industry, the makers of plastics that feed their way into almost everything we buy, the trucks that deliver them to shops - all of them rely on oil and all of them will face much lower costs.

The other (not so good) difference from the mining boom is that whereas that boom brought the government more revenue and repeated budget surpluses, this one will eat into government revenue. The prices of Australia's liquefied natural gas exports are contractually linked to oil prices. They will slide with the oil price, cutting the tax take from those projects...

Since September the share price of Santos has halved, the price of BHP has slid 22 per cent and the price of Woodside has slid 16 per cent

The December budget update factored in the slide in the oil price to that point and revised down revenue from the Petroleum Resource Rent Tax by $760 million. In the four weeks since the oil price has slid a further 20 per cent.

So why did the experts miss it? Partly because the oil price had been unusually steady for an unusually long time. For three years from mid 2011 to mid 2014 it was usually stuck between $US100 and $US110 a barrel.

But the apparent stability was deceptive. Beneath the surface the high price was making it economic for the United States and Canada to extract oil in ways they once never could have. The United States did it by fracking - using high pressure water to fracture rocks. Canada did it by refining tar sands, both expensive processes.

American production climbed to within striking distance of Saudi Arabia's. At the same time wars in Iraq and Libya cut production from the Middle East leaving the worldwide total little changed.

Until Iraq and Libya returned to production and demand from China tapered off.

Then a sudden oversupply pushed prices south until the Organization of the Petroleum Exporting Countries met in November. The US and Canada are not members of OPEC. It could have decided to wind back production to restore prices as it had done in the past, and many experts expected it to again. But that would have been a gift to the upstarts and also to Russia which isn't a member. Instead it decided to destroy their business model. Maintaining production and allowing the oil price to plummet would hurt the US and Canada far more than it would hurt OPEC.

New Canadian tar sands projects are thought to be uneconomic at prices of between $US70 and $US60 a barrel, new US fracking projects at prices between $US60 and $US50. Saudi Arabia makes money all the way down to $US25.

The latest price of $US46 is sufficient for the Middle East to rid itself of its North American rivals. When their existing projects close they won't open new ones. But that will take a while, suggesting we are set for low prices for years to come.

It is possible that the Middle East will lose its nerve, but unlikely. Qantas lost its nerve after years of a capacity war with Virgin in which it kept piling on extra seats to match Virgin's extra seats. It gave up after evaporating its profit, and prices climbed back.

But Middle Eastern producers such as Saudi Arabia are different. Unlike Qantas they have very low costs and (barring political turmoil) the ability to keep prices low for years.

And unlike Qantas there's something in it for them if the entire world grows more strongly. The International Monetary Fund says the new lower price will boost global economic growth by between 0.3 and 0.7 per cent in the year ahead. That'll mean more oil is sold, and make a fresh economic crisis less likely. Except in high cost producers such as Russia, Venezuela and Nigeria. Their economies are now in deep trouble, collateral damage of the oil war between the Middle East and North America.

For Australia it's on balance good news, news we've scarcely begun to come to grips with.

In The Age and Sydney Morning Herald

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