Why did oil prices drop in 2014

Last year, on the morning of June 12, the market price for a barrel of West Texas Intermediate Crude Oil was $107.12. When the ball dropped to announce the arrival of 2015, the price of oil did a spot-on impression and dropped 51% (to $53.45). As I write this article, the price sits even lower at $44.80.

As you read through those numbers, you are probably asking yourself two critical questions:

  1. Why did oil prices drop in 2014?
  2. How will the drop in oil prices impact the real estate market in Houston and across Texas?

If you own investment real estate in Texas (and especially Houston) you might be substantially more interested in the answer to the latter question vs. the former. However, in order to understand the impact that a significant change in market conditions can have on real estate demand and prices, you must first have a clear understanding of the causes behind the drop in oil prices as the two are deeply interconnected.

Over the last month or so, I’ve been answering those questions almost on a daily basis in one-on-one conversations with clients and long term real estate investors. In this article I will share the answer to the first question backed by empirical data in Greater Houston Partnership’s annual report.

Why did oil prices drop in 2014? Too much of a good thing

Have you ever heard politicians of both sides of the isle talk about “reducing our dependency to foreign oil” during presidential election campaigns? They might disagree on exactly how to do it (more exploration/production vs green/renewable energy), but the idea of reducing our dependency is as bi-partisan as they come.

Oil derrick in sea

Did you know that we’ve been significantly reducing our dependency on foreign oil since 2008? Courtesy of innovations in oil exploration and extraction (i.e. hydraulic fracturing or “fracking”), domestic oil production has gone from 5M to 9.1M barrels/day since 2008. The result: In 2005 imported oil accounted for over 60% of U.S oil consumption – ten years later, that figure is expected to be lower than 20%.

Wait a second – you thought reducing our dependency on foreign oil was a good thing. It is… however, oil is a commodity and as such it is governed by supply and demand. While the U.S increased its domestic production, other oil producing countries (read: OPEC) didn’t stop or taper their production. So if we weren’t importing 40% of our oil consumption anymore, what happened to those millions of barrels? They either got directed elsewhere (see: growing economies of China and India) or got stored. In fact, OPEC’s surplus in 2015 is expected to be 2.7M barrels/day!

In a nutshell, we have too much supply and not enough demand to absorb it. So what happens to price when supply is excessive? Second half of 2014 happens.

But what about demand? Well, demand for fossil fuels rises when there’s economic growth. The U.S economy has shown signs of solid growth during the last three quarters but that’s the exception to the rule these days. The Eurozone has fallen prey of their austerity measures that have stifled growth while China’s growth is gradually falling with the latest annual growth at 7.7%.

Therefore, the fall in oil prices is primarily due to a glut in supply as a result of increased production without increased demand.

Who controls Supply?

Unlike supply-demand dynamics in a free market, oil supply is controlled by a handful of nations – with Saudi Arabia as the headliner. In the past, OPEC (Oil Producing and Exporting Countries) have cut production as a way to shore up oil prices pretty much immediately.

However, this time it’s different. If OPEC cuts production while U.S producers keep their supply steady, prices would rise but OPEC would lose market share. They have a very different idea on how to cut supply. Saudi Arabia would like to see U.S production reduced rather than their own. But how can they do that? The Saudis know that the very innovations that we’ve employed to increase our production (i.e. hydraulic fracturing and shale oil) carry with them a higher cost of production. Namely, if the Saudis can extract oil at a cost of $10/barrel (making essentially any oil price profitable), wells that utilize some of the new technology have breakeven points at $50-$65/barrel.

Source: Wikipedia

Source: Wikipedia

Therefore, their plan goes something like this: Let’s keep prices low for an extended period of time and U.S production will blink first because their cost structure is so disadvantageous. While that might prove effective, low prices come with a high price to the majority of OPEC members. In fact 9 out of 12 member countries need oil prices to be between $70-$120/barrel to balance their oil revenue dependent budgets.

Deja Vu of 2008?

“But wait a second” – some of you might say – “haven’t we seen this movie before, not too long ago? In 2008 oil prices dropped in similar fashion from a peak of $145 in July to a low of $30/barrel. Then a year later, prices were back up to $89/barrel in 2009 and hit $100/barrel again in 2011.

There’s a fundamental difference between 2008 and 2014. The former drop came as a result of a substantial drop in demand due to a global economic crisis. When the economic conditions improved, so did demand and the price of oil rebounded. Last years drop came as a result of too much supply. The only way to re-establish balance between supply and demand in such an environment is to taper supply until glut is absorbed or for demand to rise sharply due to economic growth.

Impact on Economy and Employment

A sixty percent drop in oil prices will have a substantial impact despite the fact that the local Houston economy is much more diversified now than it was in the woeful 80s. According to the GHP annual report, “broadly defined, Energy accounted for 38.1% of Houston’s GDP in 2013. Of which, Oil and Gas Extraction (mining) accounted for 19.8% and Other sectors that are typically identified as part of the energy industry (chemicals, refining, oil field equipment manufacturing, fabricated metal products, pipelines and engineering) contribute another $83.9B or 18.3% of total”.

The energy sectors that will be impacted the hardest from the drop in oil prices are new exploration, oil field services and oil field equipment manufacturing. And that makes sense: Once the investment has been made to find out whether or not there’s oil in a particular area, the cost to drill and extract crude oil from the ground is very low. So existing wells will continue to  produce at max capacity as their cost per barrel still affords a handsome profit even at $40/barrel oil. If instead an oil company has to invest money into new exploration that increases the break even cost for that new well 20-30 fold. Therefore it would no longer be feasible for the company to make that investment. That’s why you have probably heard news of capital expenditure budget cuts across the board from all the major oil companies.

But let’s not get it confused. Integrated big oil companies (Exxon, Shell, Chevron, Conoco etc) will be least impacted by the current economic conditions. They sit on impressive piles of cash (always handy in a situation like this) and have hedges in place to weather longer term storms. In fact, 2015 will be somewhat of a Black Friday Sale for big oil companies as they look to pick up struggling smaller outfits on the cheap.

Since budgets for new exploration will be cut and unfeasible rigs will be shut down, oil field services and equipment will bear the brunt of it. As a matter of fact, some of the big players like Schlumberger and Baker Hughes have already announced layoffs. In 2015, there will be job losses coming from this subsector. In addition, smaller companies with unsustainable debt levels will have to merge or fold – in either case, that will result in layoffs.

However, the GHP expects net employment in the area to rise by 69,500 jobs in 2015 with the bulk of growth coming from sectors outside energy: Construction, health care, retail, professional services, public eduction etc.

Materials:

Employment-Forecast – Source: Greater Houston Partnership

Economy_at_a_Glance – Source: Greater Houston Partnership

Next Up: We will take a look at the impact of this climate of lower oil prices on the real estate markets in Houston and across Texas. Stay tuned.

 

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