How cheap oil changes the world

Consumers get lower heating bills and prices at the pump. Russia, Iran, and Venezuela face shrinking treasuries, while Saudi Arabia tries to still US drills. 

Cover Story

Like many Americans, Shernice Davis starts most days with a commute she wishes she didn’t have. The Trinidad native lives in Randolph, Mass., south of Boston, and drives 20 miles up Interstate 93, through the city, over the Charles River, and into Somerville, Mass. – a short distance from Harvard University.

On a good day, Ms. Davis says it takes her an hour. But sometimes Boston’s coagulated streets conspire to turn it into a Homeric odyssey. After she arrives at the pizzeria where she works, it’s often right back into her 2003 Volvo S80 to ferry hot pies to hungry households in the area, which means more ticks on the odometer and more money out of her pocket for gas.

Only these days, not so much.

In June, gas prices in the area were $3.73 a gallon. Now they are hovering below $2.77 – a savings of almost $1 a gallon every time she fills up. “I’ve noticed,” says Davis of the lower prices, as she sprinkles cheese and green peppers on a pizza. “Oh, I’ve noticed.”

She isn’t alone. As oil prices hit their lowest point in five years, the ripple effects are being felt around the world – from big-producing nations such as Russia and Saudi Arabia, to big-consuming nations such as the United States and China, to billions of people’s wallets.

The plunging prices are affecting the geopolitics of the Middle East, the cohesiveness of the Organization of the Petroleum Exporting Countries (OPEC), the number of drilling jobs in North Dakota, and the cost of airline tickets for the holidays.

On one level, there is nothing unusual about this. It reflects the never-ending undulation of oil prices that has been going on since the dawn of the fossil fuel era. Prices rise, and prices fall. Oil markets self-correct.

But this time around, something fundamentally different may be happening. New oil is flowing from unexpected corners, while longtime petro states watch their grasp on markets slip. Traditionally oil-hungry countries have curbed their appetite, but once-sleepy economies now guzzle vast amounts more crude than they used to. Meanwhile, growing global alarm over the threat of unchecked greenhouse gas emissions has accelerated the development of alternative fuels and efficiency measures that displace oil demand across the board.

These and other structural shifts make it “increasingly clear that we have begun a new chapter in the history of the oil markets,” the Paris-based International Energy Agency (IEA) wrote in its November Oil Market Report. Barring any unforeseen disruption in supply, most analysts believe short-term oil prices will remain well below the $100 to $110 per barrel range, around which prices had consistently hovered for three years. Depending on whom you ask, the world may continue to see oil at $60 to $50 per barrel, or lower, for months, a year – or even a decade.

What does all this mean for your utility bill and Vladimir Putin’s future?

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The first thing to understand is that oil prices, as low as they are, haven’t plunged nearly as much as during some cycles in the past. Crude prices hit $20 a barrel back in the 1990s, when a financial crisis in Asia and other forces depressed consumption. This led to a generation of SUVs and Hummers the size of tanks roaming the streets of American suburbs (some of which still do). 

Even as recently as 2002, analysts thought prices would revert back to the $25 to $30 per barrel range and stabilize after spiking in the wake of 9/11. But prices moved up as world consumption grew – and the occasional war broke out – hitting $147 per barrel in 2008.

Oil is now hovering around $60 a barrel. This represents nearly a 50 percent drop from just five months ago, when prices hit their high for the year of $115. Gas prices have followed suit, with the national US average dropping below $3 a gallon in November for the first time since 2010, according to AAA.

Behind the latest drop are some of the mercurial forces of supply and demand that, throughout the history of the Petroleum Age, have always seemed to make prices anything but predictable. New drilling techniques have opened up massive amounts of oil in places previously thought unreachable – namely in stubborn rock formations called shale and in pockets deeper under the ocean and even farther offshore. Many of these gains have come in the US, which is now rivaling Saudi Arabia for the title of world’s top oil producer, as a result of the fracking (hydraulic fracturing) revolution. But even more crude is being produced or is expected to be soon from Canada, Mexico, Brazil, Iraq, Kenya, Uganda, and other countries. Companies are even finding new oil in the North Sea, long believed to be in interminable decline from its peak in the late 1990s.

As the new reservoirs of hydrocarbons have been tapped on land and under the sea, the demand for fossil fuel hasn’t grown at nearly the rate many analysts expected. US and European oil consumption has largely plateaued because of dramatic vehicle efficiency gains and a younger generation that buys fewer cars and drives them less frequently.

Rapidly growing, car-loving middle classes in China, India, and elsewhere have been making up for the flat Western growth (China overtook the US as the world’s No. 1 oil importer in late 2013). But much of Asia’s dramatic growth has slowed recently, and analysts differ over when and by how much it will pick up again. A stronger US dollar has further dampened overseas demand by making oil relatively more expensive to buy outside the US.

“We have seen a historic development in global energy markets in shale innovation in America in the last five or six years, which has led to staggering US oil and gas production,” says Jason Bordoff, director of Columbia University’s Center on Global Energy Policy and a former energy adviser to President Obama. “Having said that, when you look at the fundamentals in the global oil market, there continues to be a great deal of geopolitical risk in key producing areas. All of it is very promising, but there’s a lot of uncertainty.”

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Whatever toppings you order on the pizza Davis brings to your door, it comes with petroleum, too. Of course there’s the gas Davis’s car consumes on the way over, but there’s also the big, red, insulated case she carries the pizza in to keep it warm. It’s likely made with synthetic fibers that get their start from oil drilled out of the ground.

Back at the kitchen, ingredients are stored in petroleum-based plastic bins. They arrive via food distributors in trucks that burn diesel fuel to spin synthetic-rubber tires across asphalt roads (all three materials are derived from oil – about seven gallons of it go into making one tire). The wheat that forms the flour to make the dough is harvested with combines that run on some form of refined crude. More daring ingredients – black olives, jalapeños, or pineapples – might begin the journey to your kitchen table on a container ship that guzzles a couple hundred tons of low-grade fuel oil each day.

In other words, the current drop in oil prices is reverberating through your pantry and the global economy. One of the biggest beneficiaries is the airline industry. Carriers spend more than 30 percent of their operating costs on fuel. In 2012, the industry shelled out $208 billion on jet fuel, nearly five times as much as it did in 2003, according to the International Air Transport Association, a trade group headquartered in Montreal. But if prices stay low, the industry could save roughly $5 billion in 2015, according to J.P. Morgan analysts. It might lead to discounted airfares if carriers don’t expand routes or decide to pocket the profits. Consumers can expect lower heating oil bills as well. The US Energy Information Administration expects heating oil costs to decline 15 percent this winter from last winter. That’s an average savings of $362 per household, due to cheaper oil and forecasts of milder weather.

With holiday shopping hitting its peak, cheaper oil should give retailers a reason to celebrate. This year, holiday sales – those occurring in November and December – are expected to rise about 4 percent over last year, according to the National Retail Federation, a trade group, though the Thanksgiving weekend was not as robust as some had hoped. Analysts ascribe that boost in part to shoppers using their savings at the pump to spend on electronics, clothes, appliances, and other gifts to spread holiday cheer.

Auto sales are up, too. In November, US sales of five of the top six automakers surged. While vehicles of all types made gains, the demand was particularly strong for trucks and SUVs, aided by lower gas prices. Sales of the Jeep Cherokee were up 67 percent, while the eight-passenger Lincoln Navigator saw an 88 percent increase.

Cheaper fuel is also a boon for businesses that run on thin profit margins such as restaurants and small businesses. David Harnik knows both of those endeavors well. He’s the vice president of the Boston Food Truck Alliance, and co-owner and head chef of The Dining Car food truck and catering company. So far, Mr. Harnik says he mostly notices falling gas prices when he fills up his car for personal use, paying $40 instead of the roughly $65 he used to pay. But the real drag on his business’s bank account are high food costs, which may soon ease off as well.

“You think about how much product travels by truck or other vessels around the country, and if that [savings] started to pass on to me, and I could feel it, and that case of cauliflower dropped $5 – that would have a real effect,” says Harnik. 

Lower food and fuel prices should help keep inflation in check, which reduces the pressure on the Federal Reserve to start raising interest rates. If oil prices fall too low, however, they could lead to deflation, perhaps nudging the US economy toward another recession. 

Cheaper energy prices have other negative consequences as well. For energy-rich states such as North Dakota, Texas, and Alaska, a prolonged period of low-cost oil means fewer jobs, lower tax revenues, and less economic activity all around. For now, drillers appear to be making up for the lower prices with efficiency gains, and most analysts don’t expect any kind of immediate drop in production from American shale formations. 

Still, investors and analysts are nervous about next year’s output. The Dow Jones Oil & Gas Index is down some 20 percent since late July, and shale companies are putting future drilling projects on hold. The IEA projects falling oil prices could cut investment in US shale next year by 10 percent. Small independent oil producers could get squeezed, in particular. They often rely on borrowed money to finance their operations.

More broadly, lower oil prices may affect investment in cleaner, safer fuels. Cheap oil prices usually discourage the development of such things as advanced batteries and fuel cell technologies. Most analysts say oil prices would have to drop a fair amount more – and stay low for a good period of time – to stall the momentum renewables and alternative forms of transportation, such as electric cars, have been experiencing. 

Nevertheless, to the extent that cheaper oil prices spur people to drive or fly more, it will mean more carbon emissions. In the US, the mostly petroleum-based transportation sector is the second largest source of greenhouse gas pollution behind the utility sector.

“High oil prices give you a good argument ... to actually find alternatives to fuel your transportation sector,” says Mihaela Carstei, a consultant based in Washington and former director of the energy and environment program at the Atlantic Council. “But how are you able to justify spending more on alternatives when the price of oil is so low?”  

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The impact of collapsed oil prices is more than just dollars and cents – it’s politics and power, too. 

Countries have long used control of energy resources to wield influence in the world – none more than the members of OPEC. Its ability to manipulate the price of oil made it a major force throughout much of the second half of the 20th century. Now it’s reeling as much as any entity as prices fall.

Its smaller, more vulnerable members, such as Libya, Nigeria, Venezuela, and Ecuador, already face severe economic problems with prices far below what they need to make oil production profitable. Iran, where oil sales are already severely constrained by Western sanctions, needs crude prices above $130 a barrel to break even – to balance its national budget – according to Citi Research, an arm of the global banking company Citigroup. Typically in a situation like this, members of the cartel would quickly and unanimously agree to lower their output to help reverse the tailspin in prices. But Saudi Arabia, the group’s most dominant member, has resisted calls for a production cut. Citi Research estimates that the country’s fiscal break-even point is about $98 a barrel, but analysts believe the Saudis are more concerned about expanding their customer base than turning a profit. Oil producers new and old are racing to fill the needs of energy-hungry Asian markets, and if OPEC cuts production, it risks ceding gains to rivals in the US, Canada, and elsewhere. 

Holding prices down makes it harder for US fracking operations to survive, since squeezing oil out of shale rock is more costly ($50 to $70 a barrel versus less than $10 a barrel for the Saudis).

That likely explains why the cartel announced it would maintain current production levels at a highly anticipated meeting on Thanksgiving Day – much to the dismay of the members who have been calling for a cut. The increasingly divergent views among its members may signal the beginning of the end of this decades-long alliance of global energy superpowers.

“It looks like oil is not going to be the same in the next 10 years compared to what it was in the past 25 years,” says Antoine Halff, head of the oil industry and markets division at the IEA. “For the last 30 or 40 years OPEC had market power, but market power is shifting from OPEC to China – from producers to consumers, from sellers to buyers.” 

Russia, too, is losing some leverage over its energy customers. It holds great sway over Europe by supplying it with roughly a third of its oil imports. But like Iran, Russia is already hamstrung by Western sanctions, and cheap oil makes it even more difficult to balance a budget that relies on oil and gas for more than half of its revenue. The dual blow will cost Russia around $130 billion to $140 billion a year – roughly 7 percent of its economy, according to the country’s finance minister, Anton Siluanov. That may give Europe some bargaining power next time it negotiates oil and gas contracts with its largest supplier. It might also make Moscow more willing to find compromise over the crisis in Ukraine, which has its roots partially in a disagreement over energy pricing and distribution across Europe. But some analysts think it will do just the opposite: Feeling cornered, President Putin might lash out more against the West and become more adventurous in Ukraine.

Even more ominous, low prices could foment social unrest in countries such as Nigeria and Venezuela, which have long bought political support with the promise of cheap, plentiful fuel. 

Probably the clearest geopolitical winner in this new energy order is the US. It’s perhaps fitting, given the enormous role the US has played in shifting global fuel flows. In November, US oil production rose to 9 million barrels a day for the first time since the 1980s. Advanced drilling techniques have unlocked supplies trapped in tight shale formations across North Dakota, Texas, and elsewhere. In October, US crude imports dropped to their lowest for the month since 1995. 

The advantage may be fleeting. Tight oil production in the US is expected to level out and decline within 10 years’ time, and depressed oil prices could speed the shale boom’s demise, which is likely part of OPEC’s strategy in letting prices fall. The success could spread elsewhere – to Mexico, China, Russia, and other nations – and give rise to some yet unforeseen energy superpower. Or some other unpredictable technology might come along to dramatically curb oil’s relevance altogether.

For now, at least, the macroeconomic edge lies with the US. Growing energy independence affords the US a stronger hand in securing its future at home, and in shaping affairs overseas. 

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How far oil prices may plummet remains uncertain – some analysts are now predicting they could drop below $50 a barrel – but few people expect them to rise anytime soon. One reason is the steady increase in the use of efficient engines and alternative transportation fuels in the US and Europe, which is helping to offset the growth in oil consumption. 

True, most analysts believe booming economies and rapidly growing middle classes in Asia, Latin America, and Africa will more than fill the void caused by slackening demand in the West. But China, India, and other countries are increasingly worried about the smog and carbon emissions that come with fossil-fuel-based transport, too, and they’re investing heavily in electric cars and solar panels that might power them. Even the gasoline-powered vehicles they will buy will go much farther on a single gallon of gas than the cars and trucks that sustained last century’s modernization.

“It’s not going to be the ‘Starsky & Hutch’ and ‘Cannonball Run’ and ‘Dukes of Hazards’ vehicles,” says Tom Kloza, chief oil analyst at the Oil Price Information Service, a petroleum pricing and news firm based in Gaithersburg, Md. “You’re not going to have ‘The Jetsons’ either, but you’re going to have something closer to ‘The Jetsons’ than those in the typical car chases we’ve seen in the movies.”  

Indeed, after decades of fretting over dwindling oil reserves – so-called peak oil – it looks increasingly possible the world might approach something closer to “peak demand” first. Predictions about the end of the Oil Age are notoriously premature, but the recent price collapse presages an eventual downward curve in demand for oil – particularly the kinds of expensive, carbon-heavy oil that producers will rely on more and more as conventional supplies dwindle. If fuel economies keep improving, and alternative fuels continue getting cheaper, civilization may be bound for a scenario forecast years ago by Sheikh Zaki Yamani, Saudi Arabia’s former oil minister:

“The Stone Age did not end for lack of stone,” Mr. Yamani is famously remembered for saying, “and the Oil Age will end long before the world runs out of oil.”

Davis isn’t thinking so much these days about the arc of the fossil fuel era as much as the numbers on local gas pumps. She likes what she’s seeing. She recently filled up for $2.79 a gallon in the Somerville area – which translates into a savings of more than $10 on a tank of gas over what she would have spent just three months ago. That could mean something new for her closet – or a night out. 

“Some weeks I save half and it rolls over to the next week where it will last me up until my next paycheck,” says Davis, a 20-something with a beaming smile that appears easily. “And some weeks, if I shop smart, and everything goes accordingly, the rest of the money gets put into something else like clothes or food – you know what I’m saying? Or to fix something on the car.”

 

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