Why oil price plunge is hurting

Plunging oil prices spark market volatility
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Story highlights

  • Crude oil prices collapsed to $26 a barrel on Thursday
  • Eric Smith: $30 crude oil is unsustainable in the long term

Eric Smith is a Professor of Practice at the A.B. Freeman School of Business at Tulane University and associate director of the university's Tulane Energy Institute. He has consulted for NGOs and energy companies. The views expressed are his own.

(CNN)Tumbling crude oil prices are creating alarm as they press down on the world's economic throat. But what can be done? And shouldn't we all be welcoming lower oil prices anyway?

It's complicated.
As the forecasts for price recovery have kept shifting into the future, some have argued that low oil prices have persisted because of the impact of leverage incurred by independent producers in general, and those active in shale oil production in particular. With aggregate debt of some $200 billion and little visible means of paying it back, these producers continue to sell existing production for whatever price is offered.
Eric Smith
But whatever the impact that this may be having, a more perplexing question for many is why these low prices are not being seen as an automatic boon to the broader economy? After all, as the price of crude has fallen, so has the stock market, with the Dow Jones down around 1,500 points so far this year, despite a recovery Friday.

Consumers not spending

However, the logic of a boon for consumers in oil importing countries only holds up if consumers oblige by actually spending gains on other economic activities. This time around, it appears that consumers are not playing along by dutifully increasing spending, but are instead shoring up highly stressed savings accounts and paying off topped out consumer loans. In addition, governments have not been shy about using the period of low oil prices to reduce fuel subsidies, thereby taking the apparent savings back.
So, without the spending of the gains from low oil prices, $30 per barrel crude oil doesn't seem to even be a mixed blessing for the net oil importing countries. But for oil exporters, it is an unmitigated disaster.
The poster child is Venezuela, which is currently suffering annual inflation rates predicted to hit the 700% range while failing to meet its citizens' most basic needs. Venezuela isn't even averaging $30 on the oil they manage to ship because their oil is heavy and sour, which results in prices in the mid-teens when Brent and WTI are averaging $30. We can probably expect regime change there.

Exporters hurting

But Venezuela is only one of eight high cost oil exporters facing a grim immediate future on both the economic and the political fronts, and you do not need to be a member of OPEC to feel the heat from low prices. Western Canada, the home of tar sands production, is also suffering from lower than average prices coupled to new constraints associated with a liberal resurgence in both the provincial and the national government. They, too, are netting prices in the teens when they can find customers.

Unsustainable prices, unpredictable future

At the end of the day, $30 crude oil is unsustainable -- at that price, more than 90% of the world's production is not covering its full cost. If we are collectively having economic and political problems with a 2-million barrel per day surplus, imagine the effect of 90 million barrels of oil being shut in for straightforward economic reasons.
To improve things, we need to stabilize the price, probably in the $25-$30 range. After that, we need to consume a large portion of the excess inventory that has built up during this price decline. Just last week, we added another 500,000 barrels to that inventory -- the United States and Europe is running out of storage capacity, and the rest of the world is not far behind. So, we can probably assume it will take around six months to hit bottom, and then we will experience a period of stable, albeit low, prices until inventories return to more normal levels. We should then assume another six months of price appreciation until we reach levels of say $50-$60, which marginally justify investment in new reserves and production.
Of course, like all forecasts, this one will be wrong -- there are just too many uncertainties involved to get this exactly right. Among these are the general health of the Chinese and world economies, the rate of growth in Iranian and Iraqi exports, progress in the war against the Islamic State of Iraq and Syria, the reaction of Russia to low oil prices, the impact of a chaotic situation in Libya and of course the tendency of our own federal government to rush forth where angels fear to tread.

Rethinking the market

As Keynes famously said, "In the long term we are all dead." But, in the long term, the truth is that we really don't need a truly free international market in crude oil anyway. In fact, we've never had one.
From the 1930s until the end of the 1950s, we had the Texas Railroad Commission. Then, from 1960 until 2014, we had OPEC. This reflects the reality that time lags and the extreme capital commitments associated with energy exploration and production operations don't really mesh with classic short-term economic cycles. So, what we really need is a better managed international cartel, an idea that harkens back to arguments Henry Kissinger and other realists have made in favor of topical, international support of the lesser of two evils rather than waiting interminably for an epic "win."
Indeed, the world would arguably be a better and more stable place with a new cartel, composed of the larger producers, and focused on producing enough oil to meet anticipated economic growth in the world economy while diverting any excess inventory into an internationally managed petroleum reserve. We already have the template for such an organization with existing international agreements designed to cover temporary shortages through collective drawdowns of strategic petroleum reserves. All we need to do is expand that template to cover surpluses.

Storing up trouble

In the meantime, it would be nice if the U.S. government's policy was aimed at easing the current pain being felt by the middle class. Unfortunately, President Obama's proposed budget is just the most recent evidence of an enduring and damaging antipathy between the administration and the hydrocarbons industry.
Included in the budget is a new $10.25 per barrel tax on an oil industry that is already on the ropes because of the effects of severe price declines. Conventional wisdom would have government wringing its hands and seeking areas where it can help to ease the pain. On the contrary, though, this administration seems more interested in making the damage worse. In fact, despite the press announcements, the proposed "fee" is nothing but a tax on consumers. Of course, a budget like this cannot pass a Republican Congress, and seems instead more about establishing a road map for future attacks on the U.S. oil and gas industry. But it also acts as an attack on the economic well-being of the American middle class.
The only good news is that the U.S. public has a clear record of voting out legislators who support tax increases on transportation, perhaps recognizing that oil remains the mother's milk of advanced economies.
Legislators who forget that fact suddenly find themselves deciding on their choice of a second career.