Oil prices declined by 16 percent since the June high. Why are oil prices declining? What’s the role in the decline? While the oil price has fundamental and political components, are the Saudis trying to hit both? Has Saudi Arabia become more pivotal economically and politically and taken too much risk?

Oil prices for both American West Texas Intermediate and European Brent have been falling, despite all the threats from the Islamic State of Iraq and Syria and all the sanctions in the world. Without those political features, oil prices would have fallen more.

WTI futures dropped below $90 a barrel this week, which is a 17-month low. Brent futures fell to nearly $92, which is its lowest low in more than two years. More declines are expected.

What are the factors that have recently driven the oil prices down? Some factors have to do with fundamentals, while others are political.

One factor is that the U.S. oil output has increased more than expected due to oil shale fracking. It increased by almost three million barrels since 2011 and this production could have been another 1.5 million barrels per day higher, but booming U.S. oil and natural gas production overwhelmed the nation’s pipeline and rail-tanker infrastructure.

Moreover, the U.S. output is expected to increase considerably more by 2020. This implies that U.S. oil imports have significantly declined which increased competition in the global oil market. U.S. imports’ share in total oil consumption has dropped to 40 percent, down from 60 percent more than a decade ago.

Moreover, the growth of U.S. production has been the main factor counterbalancing the supply disruptions on the global oil market. Half of the recent increase in world production came from U.S. and Canadian oil fields.

Another factor is the slow global economic growth in many major economies has reduced the demand for oil, consequently dropping oil prices.

The decline from 10 to 13 percent to near-7 percent in annual economic growth in China has placed significant pressure on oil prices, especially since China accounts for about half of the growth in the global demand for oil which reached a record 92.26 million barrels a day in June. A third factor is that Saudi Arabia is switching its oil policy from the swing producer that guards oil prices to a market share protector. It has disclosed that in the face of higher competition in the oil market, it will protect its market share, which means it will increase its production without much regard to declines in the oil price.

When it played the role of the swing producer, it decreased its output to prop up oil prices. Given its economic fundamentals, Saudi Arabia can afford protecting its market share now. Its government has paid all of its debt to local banks several years ago and higher oil prices have brought consecutive surpluses to its budget.

Moreover, the current oil prices are still higher than the breakeven level that balances its budget with expenses. I should remind the Saudis that the netback pricing policy that they followed in 1985 dropped the oil price from $40 to $10 within a year. A market share-maintaining policy can also negate the role of OPEC as a global price regulator.

Based on this analysis, this policy brings greater political components to oil prices. First, the new oil price reduction policy could be part of a greater deal between Obama and the Saudis to achieve certain goals in the Middle East and in the world.

They both have attacked ISIS and may want to sharpen the sanctions to inflict more damage on Russia, which depends on oil and natural gas exports as the primary source of foreign exchange. The Saudis may have another ulterior motive, which is to slow down the march of oil shale fracking by pricing this source of oil out of the market under the pretext of maintaining market share.

I do not have a precise price for oil coming from fracking but the Saudis may have figured it out and may stop there when oil prices from conventional sources reach there. But the red line for this Saudi Arabian policy is the breakeven oil price for their budget balance which is estimated to range from $82 to $90 a barrel.

They cannot go much below the breakeven price without increasing production since the demand for oil is inelastic, which implies that decreases in prices lead to declines in oil revenues without changes in production.

But between now and 2017, and even more so if the time is extended to 2020, the Saudis will find that their market share policy may send the oil price well below their red line if they keep increasing production and as the U.S., Canada and others bring another batch of three million barrels a day to the market.

In sum, the Saudis should eventually have an oil revenue problem as the increases in production will not be able to make up for the decreases in prices, particularly as production hits maximum capacity. Then the alarm bell will sound that Saudi Arabia is slipping into deficit much sooner than expected because of its ambitious spending program which is designed to appease its people after the Arab Spring.

The Saudis are taking too many risks at the same time. I should also add that if anyone is able to kill OPEC with one shot, it will be the Saudis.

What all this means is that we are coming to a new era that will substantially lead to sizable decreases in oil and gasoline prices. It is estimated that every 10 cent drop in the prices of a gallon of gasoline puts $13 billion dollars in the pockets of American consumers annually.

This should help, since all of us in the United States have suffered from low wages and salaries and meager 1.5 to 2 percent raises.

Shawkat Hammoudeh is a professor of economics at Drexel University. He can be contacted at op-ed@thetriangle.org.

For 300 years, Scotland has been part of the United Kingdom, which includes England, Scotland, Wales, and Northern Ireland. Now there is a strong movement within Scotland that calls for independence. This movement believes that Scotland has given more within the union than it receives and it is better off being an independent state.

Scotland has oil and other natural resources and also has a strong fiscal position, which is now rare in Europe. On the other hand, it has banks that are too large for its size and for its independent government to rescue if a financial crisis erupts.

At the time this article was published there was no final decision of the referendum held Sept. 18. After the polls closed it was clear the voting would be extremely close. My Scottish friends are divided where some belong to the yeses, while the others are undecided but no one subscribes to the nos.[S1] [K.P.2]

One of the major issues that has created a lot of debate about the usefulness of Scottish independence is what currency Scotland should use in carrying out transactions. To many, the pound sterling [K.P.3] is the best currency option for independent Scotland. But the recent debt crisis in the eurozone[K.P.4]  casts doubt on separating currency and state, as the state will not have control over its monetary policy.

This case will also be more so for independent Scotland because the Bank of England may turn a blind eye to this country’s problems and needs. It may also work against Scotland to punish it for its separation from the United Kingdom[K.P.5] .

My opinion is that Scotland should work for currency independence within a specific interim period. This means that in this interim period, Scotland should keep using the pound for the specific period, which may range between three to five years.

In the meantime, Scotland should work on building the Scottish Central Bank [K.P.6] and complementary financial institutions. At the end of the interim period, Scotland should have its own currency, which I call the “scot.” This can be supported by Scotland’s strong fiscal position. This should not be a big challenge for Scotland to live happily as an independent state.

Take for example Estonia, which separated from the Soviet Union in 1990, became an independent state in the early 1990s and later a member of the eurozone. Estonia is smaller than Scotland. It has 1,294,455 people according to the 2011 population count, while Scotland’s population is about 5,254,800 people. If Estonia can make it, then Scotland can make it better.

Scotland has other role models in history where countries split and adopted their own currencies. The krone or korona was the currency of the Austro-Hungarian Empire from 1892 until the empire’s dissolution in 1918. In 1924, the schilling became the official Austrian currency. In Hungary, the Austro-Hungarian currency was replaced by the Hungarian korona[K.P.7] , which was replaced by the pengo in 1927. In Czechoslovakia, the currency was superseded by the koruna.

Scotland can also learn from the peaceful and successful separation between the Czech Republic and Slovenia, which had become federal subdivisions of Czechoslovakia in 1969.

There are important political implications if Scotland separates from the UK. It may encourage other members of the United Kingdom to separate. Since the separation is rooted in the distribution of wealth and resources within the union, it may be relevant for other unions such as Russia, the United States, and Switzerland.

The post Scotland votes on independence appeared first on The Triangle.

The cold weather arrived early this fall in the Northeast and Midwest of the United States, which are the major natural gas consumers in this country. The arctic air marched through those regions, waking up the prices of the dormant natural gas, which have lagged oil prices for years. The price of one million British thermal units in Europe of this fuel is $12/MMBTU. This is three times the counter price in the United States. Meanwhile the price in Japan is $17/MMBTU, which is more than four times the price in the United States. But, the recent cold storm has increased the U.S. price to about $4.50/MMBTU, rising by 27 percent so far this year. It is the best performing commodity among the 22 commodities in the Dow Jones-UBS Commodity Index for the current fall, which is one of the coldest in more than a decade.

The cheapness and dormancy of natural gas prices has to do with the shale natural gas revolution that came after combining the vertical and horizontal drilling techniques to crack the shale formation. The revolution is a game changer that increased both the supply and reserves of this fuel in the United States and decreased its prices significantly at the household and firm levels.
It seems that the fall chill this year has awakened the natural gas price. It is expected to move up steadily but without spikes for many years to come. Its inventory has fallen this year to its lowest level since 2008. The projected colder temperatures for 2014 compared to the record-warm temperatures in 2012 should also bring higher natural gas prices than in that year. The steady upward movement in the price is also expected to continue in the next few years.

Additionally, the increase in demand (incremental demand) will continue to exceed the increase in supply in the next five years. This differential predicts steady increases but without jumps in natural gas prices. The wild card here is the speed of conversion of transportation fuels from crude oil to natural gas. Gas-to-liquids and compressed natural gas are predicted to absorb about three billion cubic feet per day of the increase in demand. There are companies that are now building the U.S. natural gas highway to be used particularly for transit buses and trucks.

In addition to the domestic demand driver coming from changes in domestic fundamentals, such as expected rising economic growth, a much stronger driver is expected to come from already-approved natural gas export terminals such as Cheniere Energy’s. The export demand may reach 5.5 Bcf/d in the coming five years. By 2020, the United States could export as much as 61.7 million tons per year of liquefied natural gas. That would make the United States the second-largest LNG exporter in the world, next to Qatar. Other deals in the licensing program are likely to push the total closer to 80 million tons per year, which would exceed Qatar’s current total of 77 million tons. This driver should be another push to natural gas prices over those years. China may play a similar role in driving up natural gas prices in the coming years as it has done with the crude oil prices over the last decade or so. China is building its power generation infrastructure and its power demand is expected to increase by ten times by 2035. Since natural gas is currently about 2 percent in the power fuel mix and there is a strong popular discontent with pollution, there should be a strong import demand for U.S. liquefied natural gas coming from China in the future.

The shale natural gas revolution is also real and a game changer for the U.S.’s energy costs. It has been felt in generating electricity at power plants and in warming American homes. It has also enhanced energy security as imports dropped and reserves increased significantly. Natural gas imports have been going down steadily. They should lead to improvements in the current account of the balance of payments.

In conclusion, people have been happy with the current $100 oil price. They should also be happy with natural gas prices ranging between $5-$6/MMBTU for the next few years.

The post Natural gas could be next big thing appeared first on The Triangle.

There has been a debate in the United States regarding China’s possible sale of the $1.4 trillion in Treasury bonds it has lent to the United States. This debate has become more relevant recently in the light of the United States’ repeated troubles in formulating its federal government budget and reducing its total government debt, which now exceeds 100 percent of its gross domestic product. There is a parallel debate on a similar issue in the United Kingdom, but the British debt is about 70 percent of its GDP, excluding the cost of bank bailouts. This debate has been carried out within the context of the loss of investors’ confidence and the consequent impact on domestic interest rates and the economy.

The answer to this debate — whether it is relevant to a country like the United States, the U.K. or Greece — depends formally on two basic factors: the size of the government debt and the type of the currency regime. The United States has a very large government debt relative to GDP, and so does Greece, but the U.K. does not. The U.S. and U.K. have a flexible exchange rate, but Greece follows a fixed exchange rate within the eurozone. This implies that those countries have different mechanisms in terms of how the loss of confidence by foreign investors affects their interest rates, exchange rates and the overall economy. Some believe that the end of the mechanism will lead to economic recession, while others trace the final outcome to the two factors: the proportion of government debt to GDP and the type of exchange rate regime, which they think could lead to expansion.

Let us first go over the theory before we find a balance between the competing theories that gives a more realistic view of the real world without any influence from ideology, whether it comes from freshwater economists or saltwater economists.

Let us start by assuming that there is a loss of confidence by foreign investors. The consequences of this shock will depend on the two factors I mentioned above.
The common belief: The loss of confidence will lead to capital outflows, which in turn induce an increase in interest rates. The final outcome is that the higher interest rates will choke off the aggregate demand and then lead to an economic recession.

Krugman’s view: Nobel Prize laureate Paul Krugman has a different view on the impact of the loss of confidence on the economy. He believes this loss will lead to capital outflows, which in turn decrease the capital account. Given the following identity:

Balance of payments = current account + capital account = 0

Following a decrease in the capital account, there must be a reciprocal increase in the current account to restore the equilibrium in the balance of payments. The trajectory that a given economy will follow will depend on the currency regime and the size of the government debt.

Fixed exchange rate within a currency area: In Greece, which follows a fixed exchange rate as part of the eurozone, domestic interest rates will soar, leading to lower demand and lower imports, therefore depressing the current account until it becomes equal to the capital account. The identity above is then the restored. However, Greece does not have the option of external devaluation through devaluing its currency to promote exports. It has the option of international devaluation through lower wages and prices to reduce imports and increase its export competitiveness in order to increase its current account. But this channel is blocked by downward wage and price rigidity and political opposition. The final result for a country like Greece is a devastating economic recession.

Unilateral fixed exchange rate: The countries that peg their currencies to an anchor like the U.S. dollar must have enough international reserves to defend these currencies in the face of large fluctuations in their foreign currency reserves. A loss of confidence by foreign investors will lead to massive outflows of short-term foreign capital. With this size of capital exodus, those countries will experience a devastating devaluation in their exchange and a paralysis in their production. The final outcome as we saw in the 1997 Asian crisis is a terrible economic recession.

Flexible exchange rate: Here the mechanism works differently from the above cases. A decrease in the capital account will lead to corresponding increases in the current account and the equilibrium until the balance of payments is restored mainly through external devaluation in the exchange rate, which should promote exports and reduce imports and maybe — just maybe — lead to economic expansion. Indeed, this adjustment is faster and less painful than the adjustment through drops in domestic wages and prices, but its efficiency is also subject to the share of government debt to GDP. It should be easier for the U.K. than for the United States because the former’s debt’s share in GDP is smaller than the latter’s.

But the real world does not go as the theory does or Krugman believes. If China, in cashing its U.S. debt, catches the Federal Reserve with its pants down, there will be an exodus by the Chinese and other foreign investors, like those in the Gulf who also have bought a sizable amount of U.S. Treasurys. If such a panic happens, it should first strike the short-term securities such as the U.S. Treasury bills. The central banks of the oil-rich Gulf countries and other OPEC exporters have most of their investments in U.S. Treasury bills. This short-term market is very vulnerable to such shocks, which should affect many operators in the United States ranging from stock brokers to businesses that need to finance their inventories. The plunge in the dollar could be disorderly, and the greenback may lose its role as the world’s foreign reserve currency. This possibility is not very far-fetched given the repeated failure of the United States to deal with its budget and debt ceiling. We will face this circumstance again in December and January as we faced it in October.

The Federal Reserve should not allow the chance to be surprised under any circumstances. It should be ready to do quantitative easing to buy up the Chinese debt if China cashes its U.S. debt. It should also have a plan to deal with the possibility of a plunge in the U.S. dollar. The Fed should consider such a plan as part of its forward guidance and new commination strategy. On the other hand, China should not surprise the Fed unless it wants to damage the U.S. economy, which is in no one’s interest.

Shawkat Hammoudeh is a professor of economics at Drexel University. He can be contacted at op-ed@thetriangle.org.

The post A loss of investor confidence appeared first on The Triangle.

It has become obvious to oil observers over the years that the oil landscape is not a constant, and it keeps changing because of diverse reasons. Many of us remember the quadrupling of oil prices in the early 1970s in reaction to an oil embargo that lasted for several months and the more than doubling of those prices following the 1979 Iranian Revolution. Those observers also understand the collapse of oil prices in the mid-1980s due to higher non-Organization of Petroleum Exporting Countries production and conservation in response to the multiple price increases in the 1970s. Many of us remember the 1991 Gulf War and the 2003 Iraq War, which both significantly reduced world oil production capacity. We recently reached a peak of $147 per barrel in summer 2008 and then subsequently collapsed to $30 per barrel at the beginning of 2009.

Now the price is about $100 per barrel, jolted up by the continuous revolution in Egypt, which has been a big participant in what’s infamously known as the Arab Spring. Some oil analysts believe that the price would be at the $147 level that it achieved in summer 2008 if it hadn’t been restrained by a recent major change in the oil landscape. This is the oil shale revolution. The combination of two existing horizontal and vertical drilling extraction techniques into one superior technique quadrupled natural gas reserves and also significantly increased oil reserves in the United States, which consumes 25 percent of world oil production (estimated now at about 89 million barrels per day). Oil production in the United States has increased by 1.8 million barrels per day in the last two years, and this production is expected to reach 3.9 million barrels per day by 2018. Moreover, the Harvard-based Belfer Center indicated in its report “Oil: The Next Revolution” that shale oil could provide the U.S. with as much as 6 million barrels per day by 2020. The recent production surge has also contributed to an increase in the world spare capacity from 1.5 to 2.7 million barrels per day. This shale revolution has also shifted the balance of power and geopolitics toward the United States and China, but the results are mixed for Europe and negative for the Gulf Cooperation Council countries and other oil-exporting countries.

U.S. production and reserve increases are likely to be reinforced by the development of shale oil resources in China, Argentina, Ukraine and other places. China’s recoverable natural gas shale resources are estimated at 36 trillion cubic meters, which are larger than those of the United States.

This has the potential of adding additional pressure to global oil prices. There is also the potential of using natural gas for transportation and ultimately providing home refueling kits so that U.S. consumers can fill up natural-gas-powered cars in their own garages.

These positive developments in oil reserves and production may have acted as a cushion that has prevented the recent jump in oil prices from significantly passing the $100-per-barrel mark as the Egyptian revolution continues to march on and the spectrum of the violence continues to rage through the volatile Middle East. But obviously the shale “shock absorber” is not large and thick enough to stop or restrain the oil price from jumping from about $90 per barrel to more than $100 in just a few days. The more important question now is whether the “shale cushion” will become thick enough to absorb shocks of the magnitude of the current Egyptian revolution. One thing that is known about the shale reserves is that they deplete much faster than conventional reserves and no one knows for certain how long they will last. We may have a few years of respite or moderation in reaction to oil shocks, but the oil landscape will continue to change, and thus this article is amenable to future updates.

Shawkat Hammoudeh is a professor of economics at Drexel University. He can be contacted at op-ed@thetriangle.org.

The post Oil shale: alternative energy? appeared first on The Triangle.

Summer is here, and this season’s travel is in an advanced planning stage if not already underway. I used to travel from New York to Amman, Jordan, and vice versa for my annual vacation almost every year. Now I cannot do that, and I have to spend some summers in Philadelphia away from my other family. For many years I paid $950 for this annual international round trip, but now I cannot travel every year because I cannot afford the cost of the trip. In the last few years, the fares have increased by more than 40 percent. The same flight now costs $1,400.

As an economist, I thought about the reasons behind this hefty increase in fares, which really has changed what I do with a long summer vacation granted to a university professor. I came up with several fundamental reasons. The first one has to do with the oil market, which affects the price of jet fuel used to fuel airplanes. The price of West Texas Intermediate oil ranged between $60 and $70 per barrel for several years, but the price has recently accelerated and is now about $97 per barrel. The sky-high cost of jet fuel in any given flight is about 35 percent of the total operating cost of that flight in 2013, rising from 10 percent in 2001. The jet fuel cost remains around record prices of more than $3 per gallon. Obviously, the more expensive jet fuel has helped to jack up the fares. Airlines are looking for a less expensive alternative, placing their hopes on the nascent biofuel industry.

Another reason has to do with the nature of the market power inherited in an oligopoly. Students in ECON 101 know that the market structure of the airline industry is an oligopoly with a differentiated product. The oligopoly itself is known for having high market concentration in its industry, a characteristic that gives it the market power to set the price much higher than the marginal cost of each passenger on the flight. Additionally, the service or the product that the airline industry provides is highly differentiated whether in terms of the size and location of the seats, the timeliness of departures and arrivals, and the food service given on the flight. You may add to these differentiating factors the friendliness of the flight attendants. This differentiation creates passenger loyalty to specific airlines, which gives these companies more market power to increase the fares above the marginal cost per passenger.

But the most potent force behind the fare increase is the destruction of capacity that is manifested in reducing the number of flights going to the same destination. Airlines have lopped off large chunks of their operations to buttress their fares. This is more obvious in U.S. domestic capacity than in international capacity. A solid example of a significant decline in international capacity is India, which has experienced a cut in capacity every year from 2009 to 2013.

The industry cancels flights that are not well paid and transfers the passengers to other flights with more passengers to make full flights. You can see the realization of this phenomenon in full flights regardless of whether you travel in winter or summer. Here, passengers have to accept the higher prices when they look for seats on the tight space on the planes. Killing capacities by airlines means higher concentration in this industry, which translates into greater market power and prices much higher than marginal costs. You add to the culled capacity the alliance between the individual airlines. While there are some advantages to having alliances in this industry, an alliance is a coordination that amounts to a soft merger in an oligopolistic industry characterized by high concentration and market power. In many cases, mergers are anti-competitive and can lead to higher prices. The government can block anti-competitive mergers but cannot block alliances.

To have lower or more reasonable airline fares, we need a reversal in those forces that have contributed to the higher fares. We need lower oil prices, increases in capacity and looser alliances. I do not see any reversal in the near future, given the fact that the economy is growing. In fact, if the low growth in the economy accelerates into strong growth, we will see a shortage in capacity, with much higher fares than what we have now. Fasten your seat belt tightly.

Shawkwat Hammoudeh is a professor of economics at Drexel University. He can be contacted at op-ed@thetriangle.org.

The post Airline fares on the rise appeared first on The Triangle.