The oil-price fall-out

The slide began after April 3, which was the last day that the price of Brent crude, the oil of the North Sea, was above $125 per barrel. It took a few weeks to become clear that this was a big shift away from the long spike that had been going on since the Arab Spring started with the Egyptian uprising last January. Prices averaged $111 in 2011, a huge jump above the $80 average of 2010. Clearly any fears about the state of the world economy – which should drag prices down – were being outweighed by the supply collapse in the Middle East, particularly in Libya.

There was also speculation. Frances Hudson, global strategist at Standard Life Investments, points out that much of this happened around investment funds that invest in baskets of commodities. These are popular choices for investors when commodity prices are high, but they disproportionately push up the oil price because the baskets are heavily weighted towards oil.

"You have to remember that there are more contracts going through that are speculative in nature rather than commercial," she says.

In March the oil price came under fresh pressure as tensions between the West and Iran intensified, but it has been downhill ever since. At the time of writing the price was around $92, a drop of more than a quarter, with many commentators forecasting that it will keep falling.

There are several reasons for this. On the supply side the Saudis have pushed up production to nearly 10 million barrels a day as part of efforts to stimulate the flagging global economy. This is 500,000 barrels more than last year's daily average and the highest level since the early 1980s, seemingly making a mockery of theories that Saudi production capacity is waning. Production in Canada and the US is also going at full pelt, while output has been recovering in Iraq and even Libya.

Demand for crude has been rising too. According to the latest figures from the US Energy Information Administration, it stands 600,000 barrels per day higher than at this time last year. Given the weaknesses of the US and Europe, this is testament to the great strides forward of China and the other BRIC countries.

There are at least three reasons why this demand rise has not prevented oil prices from falling. One is that the US dollar has been strengthening, up six cents against the pound since early May. Because oil is priced in dollars, the price tends to go down when the dollar strengthens.

Second, production has gone up more than demand and exceeded it. It is up three million barrels per day in the year to 88.9 million barrels per day versus demand of 87.9 million barrels.

Third and maybe most important, almost everyone is now fairly miserable about the global economy. Myrto Sokou, an oil analyst at Sucden Financial in London, says: "We have weaker economic data coming out of China and the US, which raises concerns about future world oil demand. And the eurozone is weighing heavily on the market, making the current summit particularly important."

The big question is where the oil market goes from here. Most analysts, including Sokou, think the price will keep on falling over the next couple of months despite the fact that an EU embargo on Iranian oil starts today and new US sanctions are likely later this month.

Frances Hudson believes that the Saudis will not let this get out of hand, however, by cutting production if the price falls too low. She cites figures from Deutsche Bank that reckon that the Saudis need a crude price of around $78 to balance their national budget.

THE NORTH SEA

Memories of the rollercoaster ride of 2008/2009, when prices swung from $147 per barrel to the mid-$30s in a few months and then stayed low for a considerable time are still fresh in the industry. This put the brakes on costly projects such as the Canadian tar sands, while closer to home some companies had their debts called in as the banks changed their attitude to risk.

According to Frances Hudson of Standard Life, the marginal cost of UK Continental Shelf production was $92 per barrel in 2011. While cautioning that this covers a variety of fields on the Norwegian and British sides, she says that some older fields will be on the verge of being uneconomic even now – never mind if the price keeps falling. The lower price will also hit profits, which will reduce companies' budgets for exploration.

Graham Stewart, the chief executive of Faroe Petroleum, takes a more sanguine view. "South of $70, people will start to worry," he says. "And they won't be able to hedge by that time because the banks will have woken up - But $90 is actually a pretty good price. The North Sea will work fine. And few people think that the price will fall significantly below that."

He adds that $90 will also be adequate for many of the deepwater fields west of Shetland, which are generally less expensive to run than older shallower fields.

REFINERIES

The so-called downstream sector of oil and gas is a classic middle-man business, with margins usually squeezed in tough times as volumes fall. Worse, the oil majors had tended to under invest in the facilities over the years, so they have generally had high capital expenditure requirements. Hence they pulled back a few years ago, with BP for example selling Scotland's only refinery at Grangemouth to Ineos in 2005.

Both Grangemouth and the English refineries have had a torrid time since the downturn, with recession-level oil demand made worse by the fact that vehicle efficiency has improved dramatically. One consequence has been that Coryton refinery on the Thames estuary, arguably the most important in the UK, went into administration in January. Last month it was rescued by a consortium headed by Shell, but only for use as an import terminal. Meanwhile as we reported last week, Grangemouth has lost about £100m in its most recent trading year. The falling price is making no difference because pump prices are falling in parallel. Until demand rises sufficiently, the refinery crisis will continue.

BUSINESS

In an environment where consumers are buying less and businesses are either afraid to invest or can't borrow, most sectors have had to learn to live with lower margins. The haulage business has been hit particularly hard, having had to adjust to less work at a time when fuel prices have leaped. As recently as 2003, crude rarely rose above $30 a barrel.

Andrew Black senior of North-Berwick-based Andrew Black Haulage is not particularly excited by the oil price drop. Working mostly in agricultural haulage, moving everything from fertilisers to vegetables, his 24-lorry business is still counting the cost of having overbought fuel at higher prices in the belief that prices would rise higher. In a business where fuel is about 40% of costs, such decisions are vital.

"It's down by about 7p a litre. We save £360 per lorry per year in fuel costs for every penny that comes off. But just because the price might have come back a bit, it's not to say it won't go rocketing back up again," he says.

Douglas Adams, an economist at Ernst & Young, adds that although most businesses outside the North Sea will benefit, many big businesses hedge and therefore take time to see any benefits. "Big users tend to be hedged out about a year," he says.

CONSUMERS

According to the AA's fuel report for June, pump prices are now almost 5p cheaper than they were in early May, with some users reporting differences of as much as 10p at the time of writing. Moreover the Coalition's latest fuel duty freeze has meant it has kept 10p per litre off fuel, while the big supermarkets are currently on the verge of a forecourt price war.

Douglas Adams of Ernst & Young says: "The price of petrol is emblematic. It's like the price of a pint. People take them as a bit of a marker for how well they are doing. So the pump price can affect consumer and even business confidence in terms of investment."

If so, this will be warmly welcomed in the high street. Various chains have gone under during the recession, from Woolworths to Game to Blacks Leisure, despite the fact that retail is at least still growing (Scottish retail sales rose 1.6% year-on-year in the first quarter of 2012).

Tony Connell, 68, a retired footballer and housing official from Glasgow, is keen to put the pump drop in perspective. "I don't think a 5p reduction is enough to make much difference to what I spend. And it will change in January when the government puts the fuel duty up. Beware of Greeks bearing gifts, isn't that what they say?"

THE ECONOMY

According to Capital Economics, every $10 drop is worth about 0.25% to annual world growth. On that basis, a sustained level of $90 this year – around $20 lower than last year – would be very welcome news in the current bear market.

However in a petroleum country like the UK, the impact will be muted. It should stimulate consumption and raise business profits, but this has to be offset against the loss of corporation tax from North Sea businesses, not least the oil majors, whose profits around the world will likely be hit by the lower price.

Douglas Adams says that one key benefit is to inflation, which at almost 3% is still nearly a percentage point above long-term Treasury targets. But he points out that the effect will be modest if oil settles around the current level, since transport is not a large part of the cost of goods.

He says: "If we get down to $80 and stay there for a long time, instead of a 2% outlook for inflation, you might be getting to 1.9% or 1.8%. It's that sort of difference."

But he stresses that falling oil prices is good news, especially in a world where the past two quarters of data have shown that the UK has now returned to recession. "It's a big win for the Western economy, but the caveat is we are talking about the oil price being back to its average level from not long ago. We would need to decline to the $70 level and stay there to see a big effect."