Loonie, oil prices could fall much further: Don Pittis

The oil industry should have seen it coming.

Prices are falling, and if history repeats itself, there is no reason they can't fall much further yet.

If that actually happens, the impact on your life will be much more significant than saving a few dollars filling up your gas tank.

About a year ago, I read a report forecasting this would happen. It wasn't exactly top secret, and hardly from a subversive group. Titled, The future of oil: Yesterday's fuel, it was published in the right-of-centre Economist magazine.

Not just a blip

The Economist article suggests that this is not going to be just a blip but more of a sea change, as global oil demand plunges permanently. The article quotes a study by Citibank saying that oil use is already falling in rich countries. Most oil is burned to propel vehicles, and increasing fuel efficiency, including conversion to electric and hybrids, means we are using less for that.

It rejects the argument that growth in places like China will push oil use ever higher, saying emerging economies will see the advantage of leap-frogging to new technology and won't pass through the first world's gas-guzzling phase. In the year since that report, an explosion of solar in India, and an analysis by Lazard saying renewables had become as cheap as fossil fuels, only made the case stronger.  

Yesterday's report that Lockheed Martin has made a breakthrough in nuclear fusion that could be ready for use within 10 years, is just the icing on the cake. 

Solar panels alongside a canal near Ahmadabad, India help power a village. There's an explosion of solar in India. (Ajit Solanki/Associated Press)

As someone who fears the scientists have climate change forecasts right, and who believes that economics really does solve our problems, I find that analysis gratifying.

However, even if this is just one more downward spin of the perpetual price ferris wheel, the impact on the global and Canadian economy could be momentous. Because between each peak in oil prices there have been some very deep troughs.

And even if you set aside the "sea change" argument, short term factors are still plenty to explain a continued sharp fall in prices.

Weeding out the high-priced producers

For a while now we've known there is no shortage of oil in the world. The question has merely been how much it costs to extract. Persistent high prices mean the industry has been finding oil in interesting places and then setting their engineering wizards to work, figuring out cost-effective ways of getting it out.

In the last decade, one of those interesting places has been under the feet of the world's biggest energy user, the United States. Horizontal drilling and hydraulic fracturing have unleashed a flood of oil and gas, turning the U.S. from a net energy importer to the world's largest producer.  

Just as in Canada's own oilsands, those same wizards have turned the marvels of technology into the commonplace, bring extraction costs down. But not far enough to undercut the oil fields of the OPEC suppliers like Saudi Arabia and Kuwait.

The International Energy Association, a Paris-based NGO that keeps tabs on the industry, predicts OPEC will not stand in the way of falling prices when they meet next month. They haven't said it in so many words but a year or so of oil prices well below the cost of fracking, oilsands and deep off-shore drilling could cut out some of OPEC's competition.

You might think that high-cost oil producers like those in the oilsands would stop producing when prices fall and wait for the price to rebound. Not so. In fact they contribute to the decline. In the first place, there is always the hope that prices will rebound soon.

But even over a longer period, the well-known economic and business principle called "loss minimization" kicks in, where a company keeps on producing even when it is not making a profit.

That's because if they stopped producing (oil in this case) they would still be incurring their fixed costs. So selling oil at a loss at least reduces those fixed costs. 

Pumping oil as prices fall

Political turmoil and military conflict in certain global hotspots has typically sent oil prices soaring. There's plenty of that now, but oil is near a four-year low. (Hasan Jamali/Associated Press)

Capital intensive businesses like offshore production and oilsands have huge fixed costs, meaning they will keep pumping out the oil for a long time, even as oil prices fall.

A longer term drop in the price of oil will be disruptive. The recent stars of the Canadian economy, Alberta, Saskatchewan and Newfoundland and Labrador, will be happy that they have spent at least some money on diversification. Unemployed roughnecks can take the jobs of the temporary foreign workers.  

But it is not all bad for the Canadian economy as a whole. Lower oil prices will result in what we might call reverse Dutch disease.

As described by NDP leader Tom Mulcair and Bank of Canada governor Stephen Poloz, Dutch disease means the loonie gets pushed up by oil exports, pricing Canada's manufactured goods out of world markets.

Prime Minister Stephen Harper and the oil industry rejected the idea when the loonie was rising. It is not clear whether they will accept the concept now that the loonie is falling, but as Poloz has often pointed out, the "true" price of the Canadian dollar, (that is, without the impact of oil), will be very good for Canadian exporters. Especially if the U.S. industrial economy continues to recover.

Traditionally, high energy costs benefit the oil producing areas of the U.S. and Canada. Low oil prices benefit the old industrial heartland.

The low dollar, while bad for Canadians wanting to travel abroad, also protects us from deflation as imports become pricier. But the deflationary effect of lower oil prices could be confusing, if not harmful, for places like the Euro area, where prices overall are on the verge of falling.

Since I started with a prediction from The Economist that seemed to get things right, I should really point out another salutary reminder from the past. In a cover edition from March 1999 titled Drowning in Oil, that same magazine predicted that a glut of crude at the time "could drive prices from today's $10 to as little as $5." 

Within weeks of that article, oil prices turned around and hardly stopped climbing before hitting their new peak of $147 US a barrel in 2008. Predicting the future, even for the big heads at The Economist, is never a sure thing. So just in case, why not take the opportunity to fill up your tank.
 

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