Oil Price Collapse Not Just Another Bust Cycle

This time, it could be long-lasting—with dramatic consequences for the climate, the economy and the global balance of power.

Oil is the most valuable commodity in world trade, so any significant change in its price—whether upward or downward—has far-reaching economic consequences. Because oil also plays a pivotal role in world politics, such shifts can have equally momentous implications for international relations. It is hardly surprising, then, that the recent plunge in prices has generated headlines around the world. Many giant energy firms have announced massive cutbacks in employment and investment, and major producing countries like Russia and Venezuela have been forced to scale back government expenditures. While some analysts speculate that prices have now reached bottom and will soon begin climbing again, there are good reasons to believe that this descent is not just another cyclical event but rather the product of something far more profound and durable.

Before examining these factors, let’s consider the sheer magnitude of the price collapse. Last June, Brent crude was selling at about $115 per barrel, ensuring substantial wealth for the major oil corporations and oil-producing countries. Most analysts assumed, moreover, that prices would remain at this elevated level. As recently as October, for example, the Energy Information Administration of the Energy Department predicted that the average price of crude in 2015 would be $102 per barrel, about the same that it’s been for the past five years. Just three months later, Brent had fallen to as low as $46 per barrel, with some experts predicting a further slide into the $30s.

Why this sudden plunge in oil prices? That old mantra, supply and demand, is mostly to blame. The high prices of recent years have been driven, in large part, by ever-increasing demand from China and other rapidly developing countries of the Global South. Chinese consumption jumped from 7 million barrels per day in 2005 to 11 million in 2014; comparable increases were posted by India, Indonesia, Brazil and Saudi Arabia. Production increased to satisfy all this added demand, but not always fast enough to keep up—thus explaining those high prices. Over the past six months, however, the fundamentals have shifted. The economic doldrums in Europe and tepid growth elsewhere have resulted in less than expected levels of demand, while the flow of crude from America’s shale formations has reached flood proportions, producing a glut of supply and driving prices downward.

Historically, the major oil powers have responded to falling prices by reining in production, thereby constricting supply and reversing the slide—but not this time around. Saudi Arabia, which lost market share to its rivals after pursuing this strategy in previous price declines, has chosen to keep pumping at current rates. At the same time, several producers, including Iraq and Russia, have increased their output. But with the US market inundated with cheap domestic shale oil and demand shrinking elsewhere, the Saudis and their competitors have been forced to lower prices in order to attract customers in non-US markets. Some have speculated that the Saudis also hope that low prices will force the Russians into curtailing their support for the Assad regime in Syria; but retaining market share appears to be their principal objective.

Whatever the combination of factors at work, the plunge in prices is having far-reaching consequences. For countries that depend on oil revenue to finance government operations, the price collapse has already inflicted serious damage. Major producers like Mexico, Nigeria, Russia and Venezuela have announced budget cutbacks, significantly impairing the ability of these governments to implement favored domestic and international programs. Russia, for example, is under pressure to reduce its military expenditures, calling into question its ability to undertake major military operations in Ukraine or other peripheral regions. Mexico has announced a budget reduction of $8.3 billion, eliminating funding for prestige projects favored by President Enrique Peña Nieto, who is already facing strong popular opposition because of rampant corruption and lawlessness at the local level. The Venezuelan government, which has long relied on oil revenue to finance social programs aimed at lifting the status of the poor, is now scaling back its efforts—further eroding public support for the socialist government of Nicolás Maduro.

If prices remain at these depressed levels for any length of time, the consequences could prove even more severe. Although President Vladimir Putin continues to enjoy strong support from the Russian population for what is seen as his aggressive pursuit of Russian national interests in Crimea and Ukraine, this could change as the current economic downturn cuts deeply into people’s standard of living. The Iraqi government, which needs high oil prices to buy new weapons and bolster its army, is having to scale back its planned offensive against ISIS. The Nigerian government is also having trouble paying its soldiers and taking the offensive against rebel forces, in this case Boko Haram. While entrenched corruption (largely the product of misappropriated oil revenue) is a major part of Nigeria’s problem, the fall in prices is making things worse; some analysts now predict that a former military strongman, Muhammadu Buhari, will defeat incumbent Goodluck Jonathan in the forthcoming presidential election. Such upsets are likely in other countries that rely heavily on oil revenue, including Mexico and Venezuela.

The fall in prices has also affected the long-range plans of many major oil companies, especially those planning costly projects in “unconventional” producing areas, such as the Arctic, the deep oceans, Canada’s tar sands and US shale formations. These projects generally turn a profit only when oil sells for $70 to $90 or more per barrel—but prices that high are now considered unattainable for the foreseeable future. In January, for example, Royal Dutch Shell abandoned plans for one of the world’s largest petrochemical plants, the $6.5 billion Al-Karaana facility in Qatar, saying high construction costs and low oil prices had rendered it “commercially unfeasible.” Chevron has indefinitely shelved its plans to drill in the Beaufort Sea and withdrawn from its shale projects in Poland; BP is scaling back its operations in the North Sea, while Occidental Petroleum is curtailing its activities in Canada’s tar sands.

Much speculation has also arisen about the viability of drilling projects in US shale reserves. Most analysts believe that drilling in the most productive formations, notably Eagle Ford in Texas and Bakken in North Dakota, will continue as before, albeit at reduced levels; however, drilling in less productive “plays,” such as the Permian Basin in Texas and the Niobrara formation in Colorado, could slow down appreciably. A lot depends on the ultimate bottom level of oil: most independent drillers, it is said, can survive a price of $60 to $70 per barrel, but a sustained rate of $40 to $50 could kill off many of them. “For rivals on the periphery of Eagle Ford and Bakken, or with acreage in more frontier plays, [2015] will be a test of endurance,” observed John Kemp of Reuters. “Some will almost certainly fail or be taken over.”

Bust cycles like this have occurred before in the oil industry, most notably in the later 1980s and ’90s, when a glut of new production from Mexico, Saudi Arabia, the North Sea, West Africa and elsewhere depressed prices and discouraged investment in frontier regions. But eventually demand, much of it from China, overtook supply, again boosting prices. This, in turn, prompted investment in new technologies that permitted drilling in previously inaccessible or noncommercial areas. With demand continuing to grow, prices rose from as low as $10 per barrel in 1998 to the recent average of $100 (except for a sharp but temporary plunge after the financial crisis of 2008). It is reasonable to assume, therefore, that prices will again recover, as occurred in 2009.

Were prices to recover quickly, we would likely see a return to business as usual, with mammoth corporate investments in shale and other unconventional sources of crude. This, in turn, would result in rising carbon emissions and pervasive environmental destruction of the sort chronicled in Naomi Klein’s new book, This Changes Everything. It would also bolster the coffers of the giant oil companies and their government backers, enabling them to better resist efforts by environmentalists to curb the consumption of fossil fuels. But will this come to pass? Although some increase in prices is inevitable—given that the current cutbacks in investment will produce an eventual contraction in supply—a return to the $100-plus levels of recent years is by no means assured. This is so for several reasons:

First, the Chinese leadership is committed to slowing and eventually reducing the country’s emissions of carbon dioxide and other greenhouse gases. Although Beijing’s drive to reduce CO2 emissions will largely focus on coal, it is also seeking to retard the growth in China’s petroleum consumption. The leadership is also wary of becoming excessively dependent on imported oil, a trend that has led to increased—and often unwelcome—Chinese involvement in the politics of major supplying countries, such as Sudan and Ethiopia.

Second, automobiles in the United States are becoming increasingly fuel-efficient as a result of rules adopted by the Obama administration in 2012. If fully implemented, these rules will require that US-made cars achieve an average fuel consumption rate of 54.5 miles per gallon in 2025—nearly twice the current level. Although lower gas prices are likely to spur increased driving and rising sales of SUVs, the increase in fuel efficiency will result in diminished overall consumption.

Finally, we are likely to witness a worldwide shift from fossil fuels to green energy. As awareness of and concern over climate change grows, governments and individuals around the world will take steps to reduce their consumption of oil. This shift will take different forms—from government-imposed fuel efficiency standards and higher taxes to multiple individual decisions to replace conventional oil-driven cars with hybrids and all-electric vehicles—but will gain momentum as the climate changes. Oil will not disappear in this process, but the giant growth in demand needed to sustain $100-plus prices may never materialize.

Given all this, it seems rather unlikely that global oil demand will expand sufficiently in the months or years ahead to re-establish the high-price regime of recent years. Prices will rise, to be sure, but could stabilize at a level well below that needed to justify costly investments in unconventional sources of crude. We would, in essence, be entering a new epoch in which oil plays an ever-diminishing role in the global energy equation.

Should this prove to be the case, we can expect a welter of accompanying changes. Many oil companies will be forced to downsize, and to abandon plans for drilling in frontier areas. This in turn will bolster the argument posed by those favoring divestment from fossil fuels that these companies are sitting on large reserves of carbon that will never be exploited—“stranded assets,” as they’re called—making these companies a less attractive long-term investment. Reduced drilling in Alberta and the Arctic would also diminish the threat to the climate and the environment. Because natural gas prices are often pegged to the price of petroleum, moreover, lower oil prices will make gas cheaper—further clouding the future role of coal and nuclear power in generating electricity. Lower prices will also make biofuels and some other energy alternatives less competitive, but, by and large, the environment will be better off.

The global political scene will also be altered. In general, power will shift from oil-producing states like Iran, Russia, Saudi Arabia and Venezuela to consuming states like China, Japan and the United States. The producers, with their revenue sharply reduced, will be less capable of pursuing ambitious political endeavors, of whatever sort. The consuming states, on the other hand, will be spending less on imported petroleum and so should see an improvement in their domestic economies. This, in turn, could tempt them to adopt a more assertive stance in foreign affairs, with unforeseen consequences. The United States, for example, could be emboldened to increase its pressure on potential adversaries like Iran and Russia, knowing they are more vulnerable to economic sanctions—but risking a dangerous backlash in the process.

How all this will play out in the months ahead is impossible to foresee. But given oil’s importance to the world economy—and the prospect for a protracted period of low or moderate prices—we could see dramatic and lasting changes in the energy economy, the climate struggle and the global balance of power.