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Oil Prices to fall again… why you should be worried

For most of us, petrol and diesel at less than £1.00 per litre can only be a good thing.  Not only are we spending less on our personal travel, but the transportation cost of the goods that we buy has been falling too.  But economists and politicians have breathed a sigh of relief now that the price of oil appears to be rising again.

The reason for the relief appears to be the agreement to freeze production between Saudi Arabia and Russia.  The trouble is that neither Russia nor Saudi Arabia is in a position to greatly increase production anyway.  So an agreement to do what they would have done anyway is no more than a bluff to bring in some much needed revenue.

The popular narrative holds that the reason for low prices is that Saudi Arabia increased its production in order to kill off the US shale oil industry.  But while Saudi Arabia has no good reason to take the hit on behalf of the frackers, its production has not risen significantly since prices began to fall in the summer of 2014.  The reason that prices have fallen is entirely due to the massive addition production from US shale and Canadian tar sands; the US producers almost getting production back to the peak reached in 1971.

North American production is now falling as fracking firms can no longer turn a profit (or even service their debts) at current prices.  But the misery is not over, as Iran, now free from sanctions, begins to ramp up its production.  Nor is there any sign that neighbouring Iraq is in any hurry to lower its production.  So even with cuts in US production, global over-supply will continue for the time being.

According to oil industry analyst Art Berman, we probably will see an OPEC/Russian agreement to cut production later in the year.  But production is not the real driver of prices at the moment; storage space is the bigger issue:

“Prices have fallen hard in step with growing storage throughout 2015 and early 2016. Since talk of a production freeze first surfaced, however, intoxicated investors have ignored storage builds and traders are testing new thresholds before they fall again… The truth is that prices will not increase sustainably until storage volumes fall, and that cannot happen until U.S. production declines by about 1 mmbpd.”

The key US storage facility in Cushing, Oklahoma is at 90 percent capacity, while storage in the USA as a whole is at 88 percent.  In Europe, the storage facility in Rotterdam is at similar levels, with many companies using tankers at sea as additional storage:

“Oil storage volumes continue to grow and that is the surest indication that production has not declined enough yet to make a difference. It is impossible to imagine oil prices rising much beyond present levels until storage starts to fall. In fact, it is difficult to understand $35 per barrel prices based on any measure of oil-market fundamentals.”

Until the backlog of stored oil can be used, and storage levels returned to normal levels, significant increases in price – of the kind that would make fracking, tar sands and North Sea drilling profitable – are not going to happen.  Indeed, according to Berman, the slowdown in global consumption means that we are more likely to see further price falls:

“The announcement last week by the People’s Bank of China that it sees room for more quantitative easing may have comforted stock markets but it only added to my anxiety about reduced oil consumption and future downward shocks in oil prices…  I hope that oil prices increase but cannot find any substantive reason why they should do anything but fall.”

To ordinary consumers, this may look like a good thing since the price of fuel is likely to remain low well into 2016.  But there is a reason why economists and politicians are worried by low oil prices.  The way they have structured taxation and public spending has been based around a profitable oil industry.  It is the income governments get from oil that goes to pay (at least in part) for our hospitals, schools, libraries, pensions and benefits.  At today’s low prices, far from providing the government with healthy tax revenues, the oil industry has become a recipient of state handouts, without which it would be scrapping rigs and laying off workers.

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