The changing political economy of oil

The recent big fall in price creates some space for new thinking, but also poses questions to which we don’t have answers

Tony PayneThe price of oil has been falling.  Last Friday the price of a barrel of Brent crude, the standard benchmark, dropped to US$61.85, its lowest figure since July 2009.  It was as high as US$115 in June this year, which means that prices have plunged more than 45%.  Moreover, most oil analysts don’t expect much of an early bounce-back, with forecasts gathering around US$70 a barrel for 2015 and not much more than US$85-90 for 2016.  It’s been reported, though, that some hedge-funds are betting on a fall to approximately US$40-45, which would be truly extraordinary.

So what’s going on?  The answer is rather a lot.  The implications of this big fall price are also considerable, and not without real opportunities if (and it is of course a huge if) political leaders have enough courage to begin to think differently about the future of the political economies they seek to govern and shape.

First, demand is falling and supply increasing – in other words, the classic mix that causes a fall in the price of anything.  We know only too well that growth in the global economy is stuttering, with the Eurozone flat and the big ‘emerging markets’ not pulling as strongly as they did.  At the same time, thanks to the rapid recent expansion of both shale and deep-sea oilfields, supply has surged and the United States has become the world’s biggest oil producer.  This represents a massive geoeconomic (and geopolitical) turn-around compared to the days of the Yom Kippur War and the 1970s generally.

Second, OPEC – the Organisation of Petroleum Exporting Countries – has decided, for the time being anyway, to acquiesce in the resulting fall in the price of oil.  It held one of its periodic meetings in Vienna in late November and decided to maintain the production level of its members at the current figure of 30 million barrels per day.  This was largely political.  Venezuela pushed hard for a modest cut in production in order to nudge prices back up and even sought to draw non-OPEC members, Russia and Mexico, into the discussion.  Iran also wanted a production cut.  But Saudi Arabia, Kuwait, Qatar and the United Arab Emirates were opposed and held the line.  They all have large foreign currency reserves and can withstand low oil prices for quite a long time.

They also have another strategic aim, which is to damage shale oil production in the US.  The big Arab oil-producing countries are undoubtedly threatened by the booming US oil industry: since 2008 it has led to a considerable reduction in US oil imports from OPEC countries.  The Saudi calculation is that, if returns from oil decline because of lower prices, the US fracking companies, in particular, will eventually have to cut back or even suspend production and further exploration.  This gambit is not certain to work, but it is grounded in the shrewd assessment that, when prices fall, the highest-cost producers are hit first and hardest.  Most assessments reckon that the US shale companies need oil at US$70-80 to break even.  OPEC, in short, is ready to play a long game.

Most of the current discussion of the falling price of oil focuses on these kinds of issues.  It is assumed that ‘business as usual’ will ultimately resume, although along the way there will winners and losers.  As the rouble has tumbled over the last week or so, Russia has been everyone’s preferred candidate for main loser.  In the British context, though, brief mention might just be made of Scotland too.  Its long ‘oil moment’ might just be disappearing before its eyes.

And yet at this moment do we not need to think bigger and bolder thoughts about the changing political economy of oil?  Is this changing in a more fundamental way?  Would it be good or bad if it was? With his usual acuity, Will Hutton opened up at least some of this terrain in a recent Observer column.  He reminded us of some of the history of the last 30-40 years, noting that ‘in the past rising oil prices were associated with recessions and falling oil prices with booms’.  He went on to forecast that, ‘if the oil price carries on falling back towards $50 a barrel, and if history is any guide, the western economy should respond – to the good’.

Put differently in old language, a fall in the price of oil on the scale we have lately seen constitutes a huge Keynesian demand stimulus to the global political economy.  Money not spent on oil can be spent on something else.  Hutton saw this and urged European Union governments to challenge the politics of austerity on the back of the fall in the price of oil and launch a major collective stimulus of the Eurozone economy, building on the Commission’s recent infrastructure spending plan.

But who else is talking like this?  And, arguably, even Hutton was too limited in his focus.  The G20, which proclaims itself the world’s ‘premier forum for international economic cooperation’, also met in November in Brisbane.  Its communiqué did focus on growth and it committed G20 members to lifting their collective GDP by at least 2% more than would otherwise have been the case by 2018.  But the methods proposed were just more of the same old ploys to free up supposedly wealth-creating private sectors.  The demand question was ignored and, as for oil, well, the word didn’t even appear in the communiqué!  Say no more.

There also lurks a bigger question still around oil.  This is the necessity that global growth becomes greener and more sustainable, and pretty quickly too, if climate change is to be managed safely.  It’s not difficult to see that more, maybe most, of the oil in the world that has not been burnt needs to stay exactly where it is – in the ground or under the sea.

On this front, falling prices work both ways.  If oil is relatively cheap, there is less of a price incentive to use alternative sources of energy: we are more likely therefore to continue with our oil fix.  But, equally, on this scenario oil companies cannot risk making the expensive investments needed to get to the more demanding (and in the case of shale dirtier) locations where oil is increasingly found.  All oil companies need to attend to their ‘reserve replacement ratios’ and are generally expected to run these at 100%, which means having as much oil in proven reserves as in production.  This is more difficult to assert plausibly when prices are low and costs of production are high.  They face the threat of being left with ‘stranded assets’.

Of course, that may be for the best for the rest of us.  The truth is that we need much more research on these questions.   For example, we need to know the best price for a barrel of oil to cost to enable us to manage most effectively the transition to a greener global economy.  Is it higher or lower than we have at the moment?