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A hard lesson on world oil pricing

Posted on January 29, 2015 by Vauxhall Advance

We are advised in financial matters that it is unwise to rely too heavily on assumptions.

In terms of investing, we are told there is no such thing as absolute certainty, but the next sentence involves the stock market always recovering, coming back bigger and stronger each time it crashes.

We are also told that the price of oil will surely recover in the long term.

Can we be so sure?

Following a 50 per cent slide in oil prices over the last six months, a report Wednesday states Western Canadian producers are set to slash $23 billion from their capital budgets. The Canadian Association of Petroleum Producers outlines a one-third reduction in spending, from $69 billion in 2014 to $46 billion this year.

The cuts are weighted against work outside of Fort McMurray, where large-scale projects are harder to start and stop, but any slowdown in Alberta’s economic engine is troubling.
The province has seen this before, of course. And more than a few folks who’d lived through booms and busts saw the vague outlines of dark clouds on the horizon.

But, many folks would have set $90 to $100 per barrel of oil as the new price floor, not only before the crash in 2008, but also this year.

That’s after a half decade of full-out shale exploration bonanza.

Over that time, North Dakota surged from a distant fifth among oil-producing American states to eclipse the combined output of Alaska and California, the former Nos. 2 and 3.
America is where the majority of Canadian oil is sold.

U.S. President Barack Obama said in Tuesday’s State of the Union Address that Americans will save an average of $750 per year on personal fuel costs. Further, he said, that country is closer than it’s been in 30 years to controlling its energy destiny.

Of course, that means production and not price, which is set in the global market and is the source of the current consternation.

It’s a generally assumed theory that the open market sets the best price, but the past six months should give some indication of how manufactured world oil pricing has been.
Once a key producer (Saudi Arabia) took the reins off, oil prices plummeted.

The question here for theoretical free market economists is why shouldn’t Saudis be able to sell oil for whatever price they see fit?

But this isn’t a theoretical crisis for Western Canada; it’s very real.

Analysts state that oil prices will have to rise eventually. The longer Saudi Arabia blows out its low-cost conventional inventory, the more it amounts to a going-out-of-business sale, and the weaker their future position becomes.

While the global petroleum industry may be hurt in the meantime, it’s not a death blow.

North American unconventional and shale reserves are still there, waiting to be developed, though at a relatively large cost to tap and a large drop-off rate thereafter.

Canadian and U.S. governments can’t control oil production companies the way Saudi Arabia can. They are unlikely to introduce a supply management system – like those currently being dismantled in the dairy and poultry sectors.

So, the hard reality of market reaction will be lower production and will bring cuts, layoffs and sharp contraction pains.

That’s the short-term outlook for Canadians, who have been happy in the past to think of our vast natural resources as a trump card in the game of world economics.

We need to start challenging that assumption.

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