Clime - The BIG US oil decision
The precipitous fall in world oil and energy prices now challenges the long term desire of the United States to become energy self-sufficient. So what can or will the US do about it, and what will this mean for long term energy prices?
To put these questions into context, we should remember that for the most part of the last 15 years, the US has run large trade account deficits. These deficits have averaged about 3% of GDP and have had two large and almost equal components: first, there was the trade deficit with China, and second was the energy deficit with OPEC.
The deficit with China has proved impossible to balance because China has pegged its currency to the USD. Further, major US multinational goods manufacturers have long used China as a cheap source of production. Today, the deficit sits at about $300 billion per annum.
On the other hand, the oil deficit has been eaten into as the US ramped up energy production across oil, gas (natural and unconventional) and coal. Importantly, when oil prices were trading at above $80 per barrel, there was great incentive to invest in ways to extract oil and gas in the US. Indeed, there was rapid development of unconventional drilling technologies that both improved and substantially lowered extraction costs.
This resulted in a sustained period of energy production growth that reached a significant milestone in 2014/15, when US production of oil per day exceeded that of Saudi Arabia.
Big US Oil decision - Figure 1
However throughout 2015, there was a sustained collapse of world oil prices as oil supply exceeded demand. It was emerging US production that created this imbalance, as OPEC refrained from cutting supply.
The Big US oil decision - Figure 2
Today, sustained lower oil prices are threatening the viability of oil production in the US. Further, it is challenging the solvency of higher cost producers and drilling rig companies. It is also sending energy-related debt into junk status and default. Apart from higher interest spreads, the growth in non-performing loans has now shown up in major US bank provisions. In recent months, US bank share prices have fallen by up to 20% and have led the US stock market lower.
Clime - The BIG US oil decision - Figure 3
So the challenge for the US Administration is this. Is the national desire to become self-sufficient in energy justification for the US Government, through the US Treasury and the Federal Reserve, to intervene in energy debt markets? Indeed, should the US Treasury provide capital assistance to the US energy sector?
These questions may stir the ire of free market proponents. However, during the GFC, the Obama Administration instructed all parts of the bureaucracy to bail out the banking sector – both through equity injections and bad loan purchases. And indeed, the US Government support under President Bush for the automobile industry provides a further precedent.
During the 2008-2010 period, US auto manufacturers, especially the Detroit Big Three (General Motors, Chrysler and Ford) faced huge financial losses as they were forced to shut down factories and lay off thousands of workers. In September 2008, the Big Three asked for $50 billion to avoid bankruptcy, to pay for health care expenses, and to freeze layoffs. Congress worked out and agreed to a $25 billion loan. (Ultimately, GM and Chrysler were forced into bankruptcy in 2009, but have since staged strong recoveries.) Based on that precedent, why would the US not do the same again for the strategically important energy sector?
The strategic and political ramifications of energy self-sufficiency are significant. Whilst a bailout of the energy sector and purchase of non-performing loans would aid the banks, the maintenance of US production would maximise pressure on Russia and dilute the strategic importance of the Middle East.
A political decision to maintain US production would involve and augment the US’s ability to reassert its strategic position in the world order. Moreover, lower oil prices will assist China in navigating its economic transition and maintain its growth, while also benefiting other oil-importers such as Japan, much of western Europe and India.
US policy may require that QE4 is implemented with oil debt acquired from the banks. By maintaining US production, it would ensure that oil prices remain low. It would mean that the economic cash flows of Middle Eastern countries and Russia are stymied. However, it would directly add to the deflationary pressures that exist and that confront central banks in Europe and Japan.
The world has entered an era of low growth and low inflation. The machinations playing out in world oil markets need to be carefully monitored by investors, for they are rather more complicated than many realise.