(PHOTO: FLCELLOGUY / WIKIMEDIA.ORG)

After a decade of big profits the oil industry is now going through a deep downward business cycle that might last for a long time. Years of investments to expand production capacity have generated an oversupply difficult to align with demand. Geopolitical tensions in petroleum exporting countries and a lack of interest in finding a common solution make it even harder. Lower oil prices have improved the balance of payments in the euro area, but an enduring low inflation rate holds the economic recovery back. All the conventional and unconventional ECB’s efforts to shake up the economy cannot do much without a robust economic policy. A paradigm shift in economics may be required to look into the new future.

The latest sign of an industry that has experienced dramatic changes since crude prices began to slip, is that one of the largest oil majors has recently been stripped of its long-held triple A rating by a financial services agency as the quick crude oil price rout adds strain to its balance sheet. The downgraded oil company seems unable to improve its costs to reflect low oil and gas prices, as its debt continues to grow.

Even a few weeks ago, Saudi Arabia, which until now has always delivered crude oil under supply contracts, sold a spot cargo of 730 thousand barrels to an independent Chinese refinery. The move went almost unnoticed on the market, but it may reveal a time bomb, as it could open a dramatic new chapter in the price war between Saudi Arabia and the rest of the petroleum exporting countries.

Over the last decade rapid-pace technological advancements in the extraction of shale oil along with high oil price sustained by a robust demand from emerging markets have stimulated large-scale investments in the oil industry and encouraged the exploitation of unrecoverable and uneconomic resources such as Canada’s oil sands and Nigeria’s offshore oilfield.

Given the natural time gap between such long-term capital equipment investments and its production startup, the resulting offer entered the market at a time when the demand for oil had already stopped rising, and more precisely when at the end of 2015 supply had exceeded demand by more than 2% or 1.9 million barrels per day pushing the OECD crude oil stocks to record highs.

If on the one hand geopolitical events in major oil producing countries such as Venezuela, Libya, Iraq and Russia have kept oil prices high, on the other hand the repeated decisions of OPEC not to cut oil production have nullified such favorable circumstances for the oil price, which has increasingly continued dropping to today’s USD 45 per barrel, equal to a decrease of 55 percent over the last two years.

By using the econometric model of vector auto-regression and assuming oil production, real activity, real price of oil and inventories as evolving variables, a recent study has quantified the effects of different oil demand and supply shocks on the real price of oil. The model showed that the initial decline in price is mainly attributable to supply increases, while the aggregate demand has recently been the dominant factor.

The shale oil revolution is a case in point for technology driven disruptive innovation which quickly changes conventional industry standards. In terms of marginal cost US shale oil can remain profitable even at an oil price of USD 20 per barrel. The current oversupply might take long before it is absorbed, thus oil prices will predictably stay low for many years, taking also in consideration that the Iranian oil is looming on the global market.

The emergence of unconventional energy resources along with rising geopolitical tensions, increasing worries about climate change and the environment, and growing dependence on the financial system lead us to think that the paradigm used in the past to analyze the oil market is outdated. Economists, analysts and researchers need to formulate new principles, frameworks and models that mirror the new economics.

The balance of payments in the euro area has improved as a result of the decline in oil prices, as each of its country imports more oil than it produces internally. As the demand for crude oil is relatively inelastic to price, lower oil prices have improved the oil trade balance by almost 1% of GDP over last two years. The improvement in the oil bill is substantially linear with the drop in oil prices at equal net import volumes.

The reduction in oil prices has also benefited individual euro area countries, which have recorded improvements in the current account balances, from a minimum of 0.1% of GDP for Lithuania to a maximum of 1.4% for Cyprus. For some countries – such as Germany, France and Italy – the oil trade balance was the main factor for the improvement in the goods trade balance.

The negative effect that energy prices have had on inflation mainly reflects the changes in oil price, although the relationship between inflation and oil price is not flawless. Liquid fuel prices have dropped by 25%, gas prices decreased by 33% percent, while the price of electricity increased by 1%, as it has almost no correlation with oil prices due to the diversity in electricity generation sources.

European Central Bank officials have underlined their commitment to fight low inflation and foster euro area growth. The political elite, though, do not seem to answer the roll call.

References: Arthur D. Little Viewpoint, 2015; Bloomberg Markets, 2016; BP Speeches, 2015; ECB Economic Bulletin, 2016; Financial Times, 2016; IEA Oil Market Report, 2016; Journal of Applied Econometrics, 2013; Reuters, 2016.