Low oil prices take their economic toll

A report by the International Monetary Fund (IMF) this week highlighted the damage sub-$50/barrel oil can do to an oil producer's economy.

Two relatively minor producers, Brunei and Equatorial Guinea have spent the last five years in recession, the IMF reported. It also mentioned a trio of bigger producers whose economies have contracted for the last three years – Libya, Yemen and Venezuela.

Structural problems

Oil prices, however, only partially explain why these countries are faring so badly economically.

Most have deep structural problems. Libya and Yemen are still politically unstable after decades of corrupt leadership and civil unrest, while Venezuela's populist social spending destroyed economic growth and resulted in hyperinflation.

Meanwhile, the impact of low oil prices on an economy that has been in recession for five years is misleading, since prices only started their fall to current levels in mid-2014.

OPEC headquarters: The oil cartel meets next month to decide on output quotas

OPEC meeting

Oil remains, however, the most valuable export of all these countries, and next month the leaders of the 13-nation oil cartel – the Organisation of Petroleum Exporting Countries ( OPEC) – meet.

They will discuss what can be done to prop up prices and alleviate the pain being felt by some of their members.

"There was a time when the oil price equation was relatively simple," says Graham Smith at Fidelity.

He explains: "OPEC decided how much oil would be supplied to the world and consumers and industry decided how much they could afford or wanted to buy. The balance between the two produced the oil price."

The 2008 oil spike

This balance, most memorably, became a large imbalance in 2008 as rapidly-growing China's massive appetite for energy conflicted with fears of dwindling supply and pushed the price of Nymex WTI to a record high of $147.27 a barrel.

Predictions of "peak oil" – reaching maximum global output, then entering decline – being reached within the next couple of decades only backed up the case for high prices.

Some analysts believed we'd never see $50/barrel oil again. Goldman Sachs even predicted a "superspike" up to and beyond $200/barrel.

The shale revolution

OPEC, as representative of two-fifths of global output, could smooth oil prices by lowering or raising its output – depending on whether it considered market prices too high or too low. But the emergence of a new breed of producers changed this dynamic.

Long considered much too costly, producers – particularly in North America – found ways to economically extract oil from shale deposits.

This revolution drove global output rapidly higher.

At the same time, demand growth from China and India began to slow. Prices fell rapidly in the second half of 2014 and have largely remained in a $40-$60/barrel range since then.

At the lowest price levels it becomes uneconomical for shale producers. But the beauty of shale production is that it can be shuttered up and then restarted almost immediately.

"US shale producers can now start or stop wells relatively easily – collectively, on an immense scale – and new US shale fields are apparently being opened up whenever the oil price rises," says Smith at Fidelity.

BP: Still 13% below its 2014 peak, the company tripled profits in the first quarter

Learning to live with $50 oil

So if oil-dependent economies cannot learn to live and profit from oil at the $50/barrel level, they must learn to become less dependent on their oil exports. Any savvy investor knows the importance of diversification.

Meanwhile, OPEC's stranglehold on the oil production industry is loosening every time a new shale operator starts to pump.

The cartel members meet in June, having already lowered output in November – to little effect.

“Why would OPEC continue limiting production at prices around $50/barrel while allowing US producers to increase theirs?” asks Smith. He adds: “The new oil order looks as if it may be starting to bite back.”

Impact on oil companies

The impact isn't just felt in the small economies of Brunei and Equatorial Guinea. London's stock exchange has a large exposure to oil stocks, and although most have rallied in the past year as they learned to live with lower prices, they remain down on their 2014 peaks.

Royal Dutch Shell more than doubled it profits from last year, but remains 18.2% below its 2014 peak. BP's first-quarter profits were triple those of a year ago, and it has rallied nearly 30% over the past 12 months, yet it remains 13% below its 2014 peak.

The final, sobering, thought goes to Fidelity’s Graham Smith: “BP estimates that, for every barrel of oil consumed over the past 35 years, two new barrels have been discovered."