Lowering Gas and Oil Prices Will Assist in Stimulating the Economy - Coursework Example

Lowering gas and oil prices will assist in stimulating the economy. However, prices should remain at their current price level to prevent a slowdown in production. INTRODUCTION We live in uncertain times. The price of Oil is an indicator to the volatility in the international system. Be it the recent financial meltdown or the rapid increase in the price of oil followed by a precipitous fall a few months later, the global economy has gone into a tailspin. The thesis of this paper is that though lower oil prices are good for the economy in several ways, they also lead to a fall in production of oil. The reasons for the same will be examined in detail. They start from disincentives to production caused by the fall in oil prices to the amount of investment that is needed for exploration, extraction and transportation. Given the deep linkages that exist between these stages of the production cycle, this paper argues that higher oil prices may not be a bad thing after all. PEAK OIL Any discussion on the dynamics of Oil is incomplete or irrelevant without a reference to Peak Oil. By definition, Peak Oil is the point in time when the maximum rate of global petroleum extraction is reached, after which the rate of production enters terminal decline. The rate of production from Oil fields, regions or countries follows an exponential growth curve and then starts to decline. This means that extraction of oil from existing sources and new sources hits a maximum at a certain point in time and then starts to decline. Thus, we are faced with the prospect of declining reserves and increasing demand. The resultant scramble for the remaining reserves dominates the oil politics of the global economy. Peak Oil means that the costs of extraction and refining increase relative to the sale price of the oil and hence this is an added factor that must be taken into account when considering the effect of reduced price of oil. As we argue throughout this paper, the reduced price serves to undercut the oil producers and leads to production freezes and diversion of oil into storage in anticipation of a higher price down the road. LOWER PRICES GOOD FOR ECONOMY Traditionally, economic growth slows as oil prices rise, although high prices might have less effect now than they had in the past, given the combination of low worldwide interest rates. The continued expansion of the global economy over the last couple of decades has been mainly due to a relatively stable oil price and conversely the contractions in the global economy have been due to “oil shocks” brought upon by extreme price volatility. This has been the case in the decades following the years of 1971-73 where oil price volatility has led to recessions in the developed world. INCREASED DEMAND The most notable aspect of lower prices is on demand. As the demand supply dynamics of any commodity show, decreased prices lead to greater demand and hence more consumption. Given the fact that the global economy is a hydro-carbon economy, the effect of lower prices and the resultant multiplier effects on all sectors are evident. Decreased oil prices leads to decrease in transportation costs and lower production costs for almost all varieties of goods. This in turn leads to stimulating the economy. HIGHER PRICES: MORE INVESTMENT The history of the oil industry is long on boom-and-bust cycles in crude prices and refining margins and short on examples of capital discipline. In the 25 years to 1998, the industrys total return to shareholders (TRS) was below that of the S&P 500 (Exhibit 1) because the industry failed to return its cost of capital over the cycle. During booms, oil companies would behave as if the world had changed permanently, investing in projects that could make a profit only if prices stayed high. The exceptions were the larger, globally integrated companies, such as BP, ExxonMobil, and Royal Dutch/Shell, which delivered TRS in line with the overall market. These companies did show capital discipline: they made strategic investments in assets and technologies, including very large oil fields and deep-water drilling, that demanded specialist capabilities and large amounts of capital, as well as investments in refining portfolios that use better technologies and are located in economically attractive places. In this way, they generated returns roughly in line with the cost of capital over the cycle. DISINCENTIVE FOR INVESTMENT The nature of the Oil market is such that the Oil majors have to invest substantial sums of money in the production cycle. Not only do they have to scout for scarce new sources of oil, they have to spend more extracting the remaining amount of oil in the existing fields. As the phenomenon of Peak Oil that we discussed before illustrates, the decline in oil reserves means that the per unit cost of extraction goes up the deeper one goes. Although this is a simplistic way of putting things, it is nonetheless recognized by industry experts that exploration costs for sources such as the Alberta Tar sands and the Alaskan Wildlife reserve entail substantial capital investment. EXPLORATION AND EXTRACTION In current conditions, oil companies should be able to build positions that are competitive under most market conditions. They can invest, for example, in new technologies and capabilities, in new territories (as ExxonMobil has done in Qatar and Schlumberger in Russia), and in the booming markets of China and India. To give themselves options down the road, they should also invest enough in less common types of oil, such as heavy crude and tar sands, and in alternatives to oil and gas, such as wind power, solar power, and biofuels .These options, which could be attractive if costs came down significantly or higher prices and margins were sustained, must be balanced against their longer-term strategic positioning. With expanding optimism on prices comes an expanded set of opportunities for Shell as some projects that were on the wrong side of the cutoff for profitable returns now become attractive enough. For Shell, those opportunities centre on unconventional gas, including coal bed methane -- extracting natural gas from coal beds -- and so-called tight gas, where geological formations make production tricky. Both are more technically complex, and at least initially more expensive, than conventional production. CAPITAL EXPANSION PLANS PUT ON HOLD As we have been discussing elsewhere in this article, the continued uncertainty of the oil prices has led to the Oil Majors scaling back on their expansion plans. To take a few examples: BP has announced that due to the decrease in oil price and the tax hike announced by the state of Alaska, it has put on hold capital expansion plans worth nearly $400 Million as it focuses on cutting costs and saving its reserves for existing projects. This does not augur well for the industry as the projects that BP is likely to put on hold are the new exploration in the Alberta Tar sands and other areas that would have yielded a good amount of reserves of Oil. Considering that these are capital intensive projects that need massive investments as the exploration costs are higher than the normal fields, it is detrimental to the future of oil. REACTION OF OPEC So far there have been two major reactions to the rapid fall in the price of oil. First we are seeing numerous companies around the world cancel or slow oil and natural gas production projects because prices have fallen too low to make their projects profitable and the outlook for future oil demand is not all that good. The second shoe that will soon drop belongs to OPEC. The cartel has seen the average price it gets for its products drop from $138 a barrel in July to $78 a barrel last week. If the current weakness in oil prices continues, the average that OPEC gets for its oil will be in the $60s. There have already been reports that OPEC has cut production in the last few weeks, and the organization has scheduled an emergency meeting for mid-November. Analysts are already talking about OPEC cutting production by another million b/d on top of the 500,000 b/d cuts they announced two weeks ago. A mid-November OPEC production decision takes any production-cut/renewed-surge-in-prices problem out of the hands of the Bush administration and leaves it to his successor. CONCLUSION As we have seen, high oil prices lead to significant investments in new capacity and add to the reserves of oil majors that can be ploughed back into the production cycle by prudent management and vision. Whereas lower oil prices spur growth and encourage demand with the resultant multiplier effects on the economy, they also lead to the Oil cartels stepping down production and moving away from investments. In conclusion, it may be said that from a consumer point of view, lower oil prices are good for the economy. However, if one were to track the long term effects of exploration and extraction in addition to refining and distribution costs and the whole process, it would be safe to say that a moderate price that is neither too low nor too high should be the norm as this leads to a win-win situation for the consumers and producers. Given that our global economy is a hydrocarbon economy, we need oil in abundant supply as well as at a reasonable cost. Thus, this is a balancing act that should not be left to the whims of the speculators and the vicissitudes of the market. Policy makers should intervene in these scenarios and ensure that everybody is well off by managing the price dynamically. Sources Dobbs, Richard (2005). Capital Discipline for Big Oil. The McKinsey Quarterly. Retrieved 07 Nov 2008 from http://www.mckinseyquarterly.com/Capital_discipline_for_Big_Oil_1724 Levine, Stephen (2008). Exxon’s Production Falls as Profits Soar. The Business Week. Retrieved 07 Nov 2008 from http://www.businessweek.com/bwdaily/dnflash/content/oct2008/db20081030_015426.htm?campaign_id=rss_daily Brethour, Patrick (2004). Higher oil prices mean expanded activities for Shell. The Globe and Mail. Retrieved 07 Nov 2008 from tp://www.theglobeandmail.com/servlet/story/LAC.20041120.RSHELL20/PPVStory?URL_Article_ID=LAC.20041120.RSHELL20&DENIED=1 Rosen, Yereth (2008). BP Says Alaska oil majors cut spending on tax hike. Retrieved 07 Nov 2008 from http://www.reuters.com/article/rbssEnergyNews/idUSN2537118220080125 Read More