Saturday, 7 February 2015

Oil Price. Good For The Economy, Terrible For Financial Markets - Part 9

This point, made in Part 8, that the global supply of oil exceeds the demand, at market prices equal to the general price of production, thereby resulting in an overproduction, and falling market prices and profits, has been referred to previously.

The view of orthodox economics is that left to its own devices, the market will clear, as demand will rise for oil at these lower prices, whilst producers will cut back their supply to the point whereby the price they obtain for a marginal barrel of oil is equal to their marginal cost in producing it. But, the continued slide in the global price of oil, shows this not to be the case. The large fall in the oil price has not resulted in any noticeable increase in demand for it. US demand, which responds more readily due to low fuel taxes, for example, has risen by only 8% compared to a fall in the price of oil of around 60%.  To the extent that demand rises, it may well be purely speculative demand, as countries like China increase their strategic stocks of oil, for future use, thereby merely cannibalising future demand.

At the same time, there has been no noticeable reduction in oil supply. On the contrary, Russia is pumping more oil than ever before. Moreover, the US, despite the high cost of some of its oil production from fracking, is producing more oil than ever.  Its up by about 1 million barrels per day from last year, and even up now compared with a few weeks ago.  The reason for this was set out in the post linked to above. Oil producers, as with the producers of most other primary products, have to invest huge sums of productive-capital. You cannot simply explore for oil, and establish a new oilfield in the way you can open a back street garage or cafe. Before investing such capital, producers need to see prices at high enough levels for long enough to justify it, on the basis of expecting to be able to make profits for a long period of time, during which the fixed capital, including the costs of exploration and so on, are recouped.

Things such as oil production are different to other forms of production to this extent. A car manufacturer, for example, advances huge sums for the purchase of fixed capital, in the form of robots, assembly lines and so on. The value of the wear and tear of this fixed capital is transferred to the value of each car, and needs to be recouped, because in order to physically replace that fixed capital, its value must be reproduced. The car maker expects to be located at a particular plant, and to be making cars there for a very long time.

But, the capital that the oil producer advances in exploration is specific to that particular oil field. They seek to reproduce it in the value of the oil they produce, because in order to continue as an oil producer, they will need to engage in future exploration to find new oil fields. But, the oil producer can take a longer term view. By experience, they know that at times the demand exceeds supply, and so surplus profits are made, and at others the opposite occurs.

It is not possible, often, having invested huge sums for such exploration and development, to simply stop production, or even to reduce production, because that would mean the expenditure already undertaken is producing no return at all, whereas the fixed capital itself will depreciate as a result of the passage of time and lack of use, and although the value of wear and tear is recovered in the value of the end commodity, the cost of depreciation is not; it is simply a capital loss for the producer. Where rigs have been shut down, for example, in Canada more than 25% of rigs have been shut down, this reflects where production costs are highest. Usually, the production is merely mothballed rather than abandoned.  In fact, as the higher cost production is shut down or mothballed, the effect is to lower the average cost of production, and thereby the general price of production.

The oil producer can, therefore, continue producing even where the market price is below their individual price of production – which includes the value of wear and tear – provided that their income exceeds the current costs of production, i.e. what they have to lay out to cover wages, materials and so on. They can do this in the hope of later recovering the value of the fixed capital, when market prices rise above the price of production. But, in the end, even if this is not the case, if oil prices stay low, the capital advanced for exploration has in any case gone, and if prices remain low, unlike the car producer, who does have to replace their machines when they wear out, they can simply choose not to invest in additional capital exploring for additional oil, until such time as market prices do rise.

Where the fall in the price does have an immediate effect is in exploration and the development of new fields. According to the FT, capital investment in such exploration and development is down sharply. Yet, despite that, the IEA continues to project a continued rise in output in the coming year. The fall in market prices, therefore, not only means that profits for the oil producers themselves are squeezed, and for some will turn into losses, it not only means, as set out earlier, that money-lending capitalists will make huge losses, in the junk bond market, as small energy producers, reliant solely on borrowed capital, default on their bonds, it also means that those sectors of capital that act as suppliers to the energy industry will suffer a sharp contraction of demand.

For example, some steel producers that supply steel pipes for oil pipelines have already seen a sharp contraction in demand for their products, whilst Caterpillar, the huge US heavy machinery producer, has suffered, as exploration and development and construction of new oilfields, and pipelines has fallen. But, given that the huge scale of investment in new production takes a long time to reach its full potential, this increase in supply can continue to hit the market for a considerable time after any new oilfields have been shelved.

As a consequence, the market price of oil can continue to fall for a considerable time, before it reaches a point whereby the excess supply is used up, and prices begin once more to stabilise, and rise slowly. That is particularly the case where some producers, who need the earnings from the oil, attempt to make up for the falling price by increasing their output, to capture additional market share. I expect that oil prices may see a parabolic spike down to between $20-25, for a short period, as this over supply continues, before supply is cut back seriously, and prices begin to rise. Prices are likely then only to gradually rise back to between $40-70 per barrel, before a new equilibrium is established towards the end of next year, at a new general price of production of around $70-90 per barrel.

The consequences of the fall in oil prices are then, as usual, contradictory, not only posing the risk of sparking a new financial crisis, but also of being detrimental to sections of capital involved in oil production itself, ahead of a new period of concentration and centralisation within those industries. However, oil production is a small element of the total social capital. The fall in the value of oil, is significantly beneficial to capital in general. I will return to an exploration of those benefits in Part 10.

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