photo: Paul Lowry
The recent decline in the oil price has triggered speculations that as many as half of the U.S. shale oil producers might face bankruptcy soon (CNBC). Analysts have further argued that this would lead to a sharp decline in the U.S. oil production, which over last five years has roughly doubled from about 5 mb/d to 10 mb/d (see the chart below). The argument then proceeds as follows: production cutbacks would, in turn, help bring demand and supply back in balance or even create a temporary shortage and that would mean that oil prices would rebound quite sharply.
While forecasting the oil price path is even more difficult (Kilian and Baumeister) than forecasting the weather (during the previous cycle, the oil price escaped the 95% medium term confidence interval twice – first on the upside in 2008 and then on the downside in 2009), there are reasons to think that low oil price might be here to stay for longer than currently assumed (Covert et al). Some of the causes of low oil prices have been already discussed extensively – slowdown and structural change in China, improvements in energy efficiency, return of Iran to the global market, etc. We would, however, like to add to this list another powerful factor – the way how bankruptcies transform the cost structure of an industry with large upfront investment and thus large fixed costs.
Bankruptcy is always painful for the shareholders and creditors of a company, but its longer term effect on the economy and society at large might turn out to be positive. Moreover, rather than halting economic activity or technological progress, it might actually facilitate them. In economics, death is often followed by reincarnation. The main reason for it is that as a result of bankruptcy productive assets become available at a fraction of their initial cost, which helps significantly reduce the cost base and per unit cost in an industry. When other players have acquired the assets of the bankrupt ones, they can price their product on marginal cost basis instead of trying to recover the initial investment. This effect might spread also to related and supplier industries.
A number of industries from telegraph and railroads in the more distant past to communication operators more recently have experienced this phenomenon (Gross). After the build up and subsequent bursting of an initial bubble, costs and prices came down and activity increased. At least to some extent the U.S. shale oil industry can be expected to replicate the earlier boom, bust and recovery cycles witnessed by some other industries. Rather than seeing dramatic permanent output cuts, it might rather go through a period of ownership change and consolidation with less than expected negative impact on output.
The above logic also helps rebuke a popular myth that Saudi Arabia is trying to push down the oil price with the aim to harm the U.S. shale oil producers. The potential bankruptcies among the shale oil producers would actually bring down the cost per barrel of shale oil and make the industry more competitive rather than eliminate it. Saudi Arabia knows this very well as many of its conventional oil fields are fully amortized and marginal cost per barrel is thus the only relevant threshold that matters. According to Saudi Arabia’s oil minister, the marginal cost of producing a barrel of oil in most of its fields is at most 10 USD per barrel (Aboualfa). It can thus continue to make substantial cash profit even at oil prices that would make many other producers across the globe suffer losses.
The potential transformative effect of bankruptcy in the oil sector globally is limited or at least slowed down because the oil sector in many countries is dominated by state-owned enterprises. Nearly all the OPEC members have state-owned companies that are not subject to a hard budget constraint in the same way as private corporations. Many non-OPEC members, such as Norway (Statoil) and Mexico (Pemex) also have state-owned oil companies. However, they are also major sources of revenue for their governments, and low earnings can cause fiscal problems for national governments, as we are seeing now in Russia. Thus, if oil prices stay low for a prolonged period of time, they might not be able to escape market forces.
A similar process to the one expected in the U.S. shale oil industry has been going on in parallel in the renewable energy sector. In April 2012 the German solar panel producer Q-Cells, once the largest player in the industry, filed for bankruptcy, only to be taken over by the Korean Hanwha later that year (optics.org). Hanwha Group is now the largest producer of solar panels globally. At the end of last year Spain’s solar energy firm Abengoa filed for creditor protection (Euronews). Whether it can escape bankruptcy remains to be seen, but if it does not, its assets and activities will be taken over by another company, which will enjoy a more favourable cost structure. Meanwhile, the price of solar panels continues to fall and the cost of solar energy is getting closer to being commercially viable without government subsidies.
To summarize, rather than halting shale oil production and slowing down the development of renewable energy, the recent fall in oil prices might actually facilitate adjustment in these sectors in the medium term. As a result, the cost of alternative energy is likely to decrease further and the oil price might stay lower for longer than currently assumed. More than that, although saying this goes against the advice given in a famous quote from Charles Dickens, the oil price might never return to levels above 100 USD per barrel.
Aboualfa, Fadi. “Full MEES Interview With Saudi Oil Minister Ali Naimi.” Oilpro.com. December 2014
CNBC. “Half of US shale drillers may go bankrupt: Oppenheimer’s Gheit” 11 January 2016
Covert, Thomas, Michael Greenstone, and Christopher R. Knittel. “Will We Ever Stop Using Fossil Fuels?”Journal of Economic Perspectives, Winter 2016.
Euronews. “Spain’s solar energy firm Abengoa begins insolvency proceedings.” 25 November 2015
Gross, Daniel. “The bubbles that built America”, CNN Money, 16 May 2007
Kilian, Lutz, and Christine Baumeister. „Forty Years of Oil Price Fluctuations: Why the Price of Oil May Still Surprise Us.” Journal of Economic Perspectives, Winter 2016.
optics.org “”Q-Cells ‘saved’ as creditors approve Hanwha buy-out” 29 August 2012
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