SECTION ONE

1.0 INTRODUCTION

1.1 OIL PRICES AND THE SHIPPING INDUSTRY

Crude oil prices have many effects on our daily life from gas

that we use in our daily commute to commodity products that we

frequently buy in our neighborhood market. Not many of us were

paying much attention to oil prices until 2004, since the average

of crude oil was trading between $22 to $26. In 2004 the big climb

started with double digits reaching $50 average in 2005, $71

average in 2010 & above $90 average in 2011. But what happened

during this period that drove the prices 2-3 times higher than its

trading average? The Iraq war of course has its effects, but it is

not the sole reason for this global development. After researching

this issue, I found out that the increased influence of OPEC as the

monitor of production capacity, as well as increased interest in

oil futures drive the oil prices upward. Currently there are 12

member countries of OPEC, and most members are unsurprisingly from

Gulf States and Africa.

Again, the addition of oil prices in futures also brought the

speculators where the higher prices meant better returns, one

recent estimate suggests that speculation in prices is effected at

40% by speculation – in other words if the speculation is banned,

the oil prices are estimated to be between $50-$75 per barrel.

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1.2 STATEMENT OF PROBLEMS

In shipping terminology, Bunker is the term that is used

relating to oil prices, and Bunker fuel is now a considerable

expense to shipping lines. Ship owners started to use fuel

surcharges to recoup some of the increased costs that they face so

that they pass some of these costs on to the importers. Other than

passing the costs, liners are also implementing other strategies to

cover this variable cost, below are some of the trends that I

discovered in my research:

1. Designing more efficient vessels

In order to maintain profitability, a large focus is dedicated

on the design part. Last year, Maersk line ordered the biggest

order in maritime history, with 10 container ships of 18,000 TEU

capacity each and when sailing, the ships will save approximately

50% on fuel consumption compared to the current fleet. Each vessel

will cost an average of $190,000 million, but Maersk believes the

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investment will have a very short period of payback time due to

cost efficiency on fuel. Another advantage of the new ships is that

they will be 100% recyclable when they retire after 25 years of

service.

2. Vessel speed 

This is an interesting example as many of us do not pay

attention to this fact, but liners have huge advantages when they

change the vessels’ sailing speed (AKA knots). A good example that

I found is that increasing service speed from 23 to 26 knots for an

average 13,000 tons vessel is an extra cost to the line of more

than $50,000 one day. 

3. Vessel Scale

Before the 2008 crisis, as a result of strong growth in

container trade routes many shipping lines embarked ambitious

growth plans to upgrade their fleet. For the last 4 years, the

capacity increase of 6.56 million TEU’s accounts for 70% increase

in new space. Another interesting example is in 2007 the number of

ships bigger than 7500 TEU’s was 147 vessels, and in 2011 this

number increased to 399 ships. The number is even more fascinating

when you look at over 10,000 TEU capacity ships; in 2007 the number

of ships over this capacity was only 2 and last year this number

reached 91. A good example for savings per TEU is for a 5000 TEU

vessel, Bunker cost per day is $8.7 whereas for a 12,000 TEU vessel

the cost is $5.4 per day – passing savings close to 40%.

4. Outsourcing Fuel Supply

Another trend that I found during my research is that more and

more liners are outsourcing their fuel supply to professional

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companies who focus on this issue alone so that liners can focus

more on their core business. These companies develop comprehensive

fuel strategies that effectively manage oil prices as well as

finding the right type of fuel to meet government regulations.

1.3 AIMS AND OBJECTIVES

For the two biggest publicly traded U.S. package delivery and

logistics companies, fuel makes up about 9% of operating expenses

or nearly $10 billion annualized, based on the most recent

quarterly data. Trucking companies see a similar benefit. As with

the rails, reduced fuel surcharges shift some of the benefit to

commercial and retail customers — a win either way.

Like consumer discretionary, the performance record for

transports has also been positive during prior big oil price

declines, though it is not quite as consistent. The

underperformance during the 1997–1998 oil price decline was driven

by sharp declines in the railroad stocks, due in part to weak

pricing power and a more challenging regulatory environment. Still,

on average, the transports sector outperformed by 7% during the oil

price declines, and by an additional 6%, on average, during the

next three months.

1.4 THE OIL PRICE ISSUE

Over the last forty years, one of the most difficult

transportation policy questions has been the issue of the price of

oil and its associated impact on transportation systems1. Since the

1950’s the North American economy and its transportation system

have become increasingly dependent on oil both in terms of its

production of goods and services, and their distribution from

production centers to market consumption centers. Oil drives a

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large part of the costs of the production of agricultural,

manufacturing, and service industries. Furthermore, as industries

have globalized over the last thirty years the low price of oil has

been critical in allowing logistics chains to become more and more

elongated. As a result of economic globalization, more and more of

the U.S. Gross Domestic Product (GDP) has become dependent on

international trade and movements across the world.2 It is

estimated that whereas only five percent of U.S. GDP was generated

from trade in 1950, the growth of international trade (See Exhibits

2 and 3) by the year 2000 resulted in twenty percent of GDP being

generated by international trade, and that by 2050 it will be fifty

percent.

The transport systems that support this growth in “economic

globalism” are very dependent on oil. Whether it’s the ships that

carry containers with consumer goods from Asia and Europe, or the

oil tankers bringing fuel oil to the U.S., or bulk carriers moving

coal, ores, and grain, marine shipping has been driven by economies

of scale being generated by faster and larger ships, and steady if

not falling oil prices. Equally, in terms of inland distribution

whether by truck, rail, or inland water, steady or falling oil

prices have allowed the growth of an efficient distribution system

using existing infrastructure systems that had adequate capacity.

Interstates were built and maintained by Federal and state

government, railroads maintained by the private railroad companies,

and port and inland water systems have been built and maintained by

the Federal and state government, and the private sector.

In the global economy and both the internal and external

transportation systems of the United States, significantly

increased oil prices will have a very large impact on a number of

demand and supply factors, including:

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The ability to maintain and grow the global economy

The costs of both marine and inland shipping

The competitive relationships and role of inland shipping

services (i.e., modal share).

1.5 THE ABILITY TO MAINTAIN AND GROW THE GLOBAL ECONOMY

In the short run, higher oil prices will undoubtedly have an

impact on the rate of growth of the global economy, as oil has such

a significant role as a factor of production in agriculture, basic

raw materials, manufactured products, and service industries. For

agriculture, oil impacts as much as 20-50 percent of total costs,

for raw material industries 20-30 percent, for manufacturing

industries 10-20 percent, and for service industries 5-10 percent.4

However, while increased oil prices will slow the growth, and in

the short term may limit or cut production, there are in many cases

a wide range of substitutes for oil that could replace oil given

time. For example, in the generation of power, the electricity

supply can within the short or medium term switch from oil to

natural gas, coal, nuclear, solar, and even wind alternatives. In

addition, a range of conservation measures may be applied on the

demand side. Changing to these new fuel sources will allow the

production and consumption markets to expand after a short-term

hiatus.

As a result, oil will tend to become more focused into

specific “products” such as, fertilizers for agriculture, or feed

stock for plastics and chemicals as low cost substitutes will be

harder to develop in the short and medium term (0-10 years) in

these areas. In the longer term (10-15 years)5 liquefied coal or

cellulose-based alternatives (e.g., bioplastics) will likely be

developed that can substitute for oil. Overall, therefore, while

the prices of today may be moderated by substitution, the worldwide

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expanding demand for oil is likely to be a consistently upward

pressure on oil prices, and result in oil prices stabilizing at far

higher levels than were experienced in the 1990’s or before 2005.

This will result in a short or even medium downturn in the U.S. and

world economies shaving 1 or 2 percentage points per year off U.S.

GDP.

1.6 THE COSTS OF MARINE AND INLAND SHIPPING

In the last five years the transport industry has experienced

a five to eight fold increase in the price of fuel for marine and

inland shipping (i.e., as a result of a price increase in crude oil

from $20 to $140 per barrel). This causes a major “dislocation” for

industry that may significantly impact the current distribution

pattern of goods and services. In the year 2000 fuel represented

only 20 percent of transport operating costs, recently at $140 per

barrel it represents over 50 percent, and were the oil price to

rise to $200 a barrel, it would be over 70 percent of operating

cost.

Transport prices have risen by nearly 100 percent between 2002

and 2008, and could increase by almost another 300 percent if oil

prices increase to $200 per barrel. A one-dollar rise in world oil

prices leads to a 1 percent rise in trade transport costs. In terms

of the marine and inland transport movement of a 40-foot container

from Shanghai to Columbus, Ohio, the total transport cost was

$3,000 when oil prices were $20 per barrel in the year 2000. Today

at $140per barrel, the cost is $8,000, and should oil prices rise

to $200 per barrel transport cost would rise to $15,000 per FEU.

The prices of food, consumer goods (e.g., electronics,

furniture, and clothes), and capital goods items like cars and

houses are all likely to suffer from continuing oil price shocks.6 7

It is estimated that the realignment of prices will result in a

significant set back in the growth of the world economy and both

suppliers and consumers will face a change in “equilibrium” of the

economy, with suppliers having to increase prices to pay for the

increased production and transport costs, and consumers having to

reduce demand as prices rise. A good example of the impact of

increased oil prices on transportation is shown by the change in

the supply and demand conditions for steel production. Chinese

exports of steel to the U.S. are now falling on a year over year

basis by more than 20 percent, while U.S. steel output is rising by

10 percent a year.

While production costs in China and the U.S. are very similar

at $600 per ton of rolled steel (due to exchange rate changes), the

extra shipping cost faced by Chinese steel of $100 per ton is

making it uncompetitive in U.S. markets (See Exhibit 5). The new

equilibrium will result in a short to medium term change in the

market. In effect, the elongated supply chain from China has been

neutralized by higher oil prices. As the market had become

reflective of transport conditions 10 to 20 years earlier in terms

of volumes transported and supplied to the market,7 the result

should be a short-term shake out among producers, and a more

competitive market as demand falls. Lower cost producers will gain

market share at the expense of high cost producers. All producers

will look for cheaper ways to supply the market, and consumers will

look for competitively priced goods. Clearly pressure will be on

the transport supply industry to find more cost-effective

alternatives.

1.7 LIMITATION OF STUDY

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SECTION TWO

2.0 LITERATURE REVIEW

2.1 THE HISTORY OF OIL PRICES

Since 1970 and prior to 2004 the world has suffered a number

of oil price shocks largely due to the actions of OPEC, and Middle

East wars (See Exhibit 6). However, the recent oil crisis has

resulted in the nominal price of oil far exceeding any previous

crisis at $140 per barrel. In nominal terms, the refiner

acquisition cost of oil (which is typically 95 percent of domestic

market price) did not exceed $40 per barrel, prior to 2006 and

major price spikes were largely due to Middle East wars, such as

the Arab oil embargo (1973), Iran/Iraq War (1982), and Persian Gulf

War (1992). That situation changed after the year 2000 when non-

supply issues like the growth in world oil demand (2003 to 2007)

began to impact oil prices. From a low of $10 per barrel in 1999,

oil prices rose quickly in nominal terms to nearly $70 per barrel

in 2006 and to $140 per barrel in 2008.

Even in real terms (See Exhibit 7), oil prices (adjusted for

inflation) remained within historic norms up to 2006, when the oil

price per barrel was at $70. The price was lower than that in the

1982 Iran/Iraq war when the oil price peak at over $90 per barrel

in 2006 dollars. However, after 2006 it is clear that there is a

major change in the market with the average 2008 price rising

dramatically to $125 in 2006 dollars, and peaking at over $140 per

barrel in 2008 dollars. According to the International Energy

Agency (IEA), the recent rise in oil prices reflects the impact of

global demand factors. For the first time world demand is

considered to have become a significant influence on oil prices and

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heralded a new oil price equilibrium. For example, Mr. Rick Wagoner

CEO of General

Motors described the new oil prices as a major dislocation in

the world economy to which his firm would need to adjust. It was

not considered a temporary impact that, in the case of previous

“war driven” oil crises, would slowly subside as peace was restored

to the Middle East. Rather, it represented a major permanent

structural economic shift that would need to be responded to on a

permanent basis, representing not a temporary shortage of supply

but long-term growth in world demand that existing world supply

could not meet.

2.2 THE FUTURE RANGE OF OIL PRICES

From the review of discussion and historic data on oil prices,

it is clear that there is much uncertainty about how oil prices may

change in the future. To evaluate how the potential range of oil

prices might affect the transport industry, three potential

scenarios were developed. These include a low (optimistic) case,

high (pessimistic) case, and a central case.

In order to prepare these scenarios the following procedures

were used. First, historic data from years 2000 to 2007 were

derived from the Energy Information Administration (EIA database).

In addition, forecasts from the EIA Short Term Energy Outlook

(2008-2009)13 were used that reflected recent price increases for

the first six months of 2008. This established new forecasts for

years 2008 and 2009. Second, in order to develop long-term

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forecasts, the growth rates developed by the EIA for long term

central, high, and low case scenarios were used.

The EIA average annual growth rates were linked directly to

the July 2008 short term values, and forecasts were generated to

2020 for the central, high, and low case scenarios. The forecasts

are shown in Exhibits 8 and 9 in both nominal and constant (2008)

dollars. To develop the nominal dollar estimate for the prices of

oil, the constant 2008 dollar values were inflated by an inflation

rate of 3 percent per year.

2.2.1 OPTIMISTIC SCENARIO (LOW CASE)

Under the optimistic view or low price scenario, new oil

supplies and substitutes are gradually brought on line (i.e., over

2-3 years) and then oil prices fall to a new higher equilibrium

level of $60-80 per barrel. This reflects the fact that supply

conditions improve and that an increase in supply will return the

economy to a moderate or high growth strategy. While conditions

will not be as advantageous as they were in the 1990’s, increased

oil supplies and improved energy use productivity result in a new

equilibrium level for the economy that will operate very

efficiently with oil costs only double or triple what they were in

the 1990’s. This scenario is similar to what happened after the

Iran-Iraq war when oil prices peaked at $97 compared to the $140

recently experienced.

The difference with that situation is that oil returned to $20

- $30 per barrel after five years of a steady fall, instead of

halting at a higher level of $60 - $80 per barrel forecast under

this scenario. This scenario assumes that OPEC would expand output

so that it’s nearly keeping pace with the expanding demand in China

and India so that while world demand is high, so is supply. As a 12

result, the ability to stabilize oil prices even at a new higher

equilibrium price floor will lead to renewed growth in the economy

and a gradual rise over 3 to 5 years in GDP growth to the 1990’s

levels of 3 to 4 percent per year.

2.2.2 PESSIMISTIC SCENARIO (HIGH CASE)

Under the pessimistic or high price scenario, the expansion of

world demand is so strong that the new equilibrium level will be

consistently rising to over $200 per barrel, and that this change

is likely to be permanent, and specifically, due to the growth of

Asian and Latin American markets. In this scenario, it is envisaged

that despite OPECs best efforts to expand production, the use of

supply substitutes, and efficient energy use, it is still not

possible to keep world oil production up with expanding world

demand for oil. Rising long-term oil prices dampens the U.S.

economy’s ability to grow so that growth rates moderate to 1 to 2

percent per year as increasing oil prices almost completely absorbs

much of the productivity gains and growth of the economy.

While living standards rise, such slow growth will reduce the

dynamism of the economy and its ability to rebuild itself every ten

to twenty years. In the worst case, the U.S. may suffer from the

“European disease” of a “mature economy,” or the “Japanese disease”

of stagflation.

2.2.3 CENTRAL SCENARIO (MIDDLE CASE)

As a result, we have two very different perspectives on oil

prices as shown in Exhibit . A third, central scenario would be a

stable or slightly falling set of oil prices based on the idea that

increasing world demand will strain existing oil supplies, but that

new substitutes would gradually become available (e.g., ethanol

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based on sugar cane/biomass), and new oil finds will be brought on

line such as the recently U.S. Geological Survey announced Bakken

oil finds in North Dakota, Montana, and southeastern Saskatchewan.

This suggests an intermediate course that would fall between the

optimistic and pessimistic cases. However, this scenario will see

long term oil prices at least quadruple in nominal terms what they

were in the 1990’s. In this scenario, the pace of the economy

quickens after two or three years of very low growth reflecting the

current slowdown.

Increased growth results from increased oil production,

substitute fuels, and energy use productivity, which gradually

outpace growth in world demand for oil. This leads to stable or

slowly falling oil prices at $100 to $120 a barrel by 2016 in

nominal prices, but remaining under $100 per barrel in 2008 prices.

After six to ten years of 2-3 percent GDP growth, the new

equilibrium oil price of $90-$100 enables U.S. economy to increase

3-4 percent GDP growth per year. This middle-case equilibrium price

for oil reflects the balance between OPEC and the world oil

production capability, and the expansion of world demand. It

assumes major gains in energy supply, the development of substitute

fuels, and improved energy use productivity (e.g., higher fuel-

efficiency standards for automobiles), not just in the U.S., North

America, and Europe but in Asia as well.

2.3 A BRIEF HISTORY OF THE OIL CRASH

On Sunday June 22, 2014, two tankers loaded 1.3 million

barrels of crude at the port of Tobruk in eastern Libya and

signalled the end of the decade-long boom in oil markets. Just

three days earlier, the price for benchmark Brent peaked at almost

$116 per barrel, the highest level for the year, before beginning a

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relentless slide that would see prices cut more than 60 percent

over the next seven months.

In retrospect, the re-opening of Libya’s ports and oilfields,

which had been closed for months by unrest, marked the oil market’s

tipping point. Libya’s production, which had dropped to 250,000

barrels per day (b/d) in April, May and June, from around 1.8

million b/d before the civil war, rebounded to almost 900,000 b/d

over the next three months. The increase was significant not

because of the volume involved. World production and consumption of

oil is around 93 million b/d so the extra 600,000 b/d amounted to

less than 1 percent of daily consumption.

The resumption of Libyan exports mattered because it was so

unexpected. Two weeks earlier, Reuters had warned Libya’s crude

exports “could fall to zero” within days as the authorities

struggled to contain a wave of protests paralysing oil fields and

ports across the country. Expecting more unrest, hedge funds and

other financial investors had amassed a record long position in

crude-linked futures and options positions equivalent to 650

million barrels of oil in order to bet on a further rise in oil

prices. With Libya descending into chaos, Syria locked in civil war

and Islamist fighters racing across northern Iraq to threaten the

country’s oil fields, fund managers were anticipating a further

loss of oil supplies, and it seemed the nearest thing to a sure

bet. Instead, the Islamists failed to capture Iraq’s key producing

areas and Libya’s output began rising, catching investors long and

wrong in the paper markets, and scrambling to turn their positions

around.

By the beginning of September, fund managers had slashed their

net position in Brent and WTI-linked derivatives by 60 percent, the

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equivalent of more than 400 million barrels, in less than three

months. Unsurprisingly, amid this massive liquidation of positions,

the price of Brent fell more than $13 per barrel, 11 percent, to

the lowest level for more than a year.

Much worse was to come. The price of Brent fell to $86 per

barrel at the end of October, $70 by the end of November, $57 by

the end of December and less than $47 on January 13, 2015. The

spectacular slide in prices was comparable to previous slumps in

1985-86, 1997-98, 2000-01 and 2008-09. It has plunged the industry

into crisis. Major international oil companies and small

independents have cancelled billions of dollars worth of projects

planned for 2015 and 2016. Schlumberger, the world’s leading

oilfield services company, is axing 9,000 jobs (7 percent of its

worldwide workforce) as exploration and production activity slows.

And the heavily-indebted shale drillers at the heart of the

American energy revolution have raced to idle rigs and layoff crews

to conserve cash. But if the resumption of Libyan oil exports was

the immediate trigger for the plunge in oil prices, the seeds were

sown years earlier at the height of the boom.

2.3.1 DEMAND DESTRUCTION

In 2005, already spooked by the rise in oil prices to $55 per

barrel, up from less than $20 at the end of the 20th century, U.S.

legislators approved the Energy Policy Act. The act, which passed

with substantial support from both Republicans and Democrats, and

was signed into law by President George W Bush, instructed fuel

distributors to begin blending increasing amounts of ethanol into

the gasoline supply. In 2007, responding to a further increase in

oil prices to around $70, Congress passed the Energy Independence

and Security Act, which stiffed the blending targets even further

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and raised fuel-economy standards for vehicles sold in the United

States. The Energy Policy Act and Energy Independence and Security

Act were just two instances of a raft of new laws and government

regulations introduced in the United States and across the other

advanced economies between 2004 and 2014 to promote energy

conservation and reduce demand for increasingly expensive imported

oil. In the meantime, the soaring cost of gasoline, diesel and jet

fuel encouraged motorists, truck operators and airlines to do

everything possible to reduce fuel consumption.

The number and length of discretionary car journeys began to

fall, consumers bought smaller and more fuel efficient vehicles,

trucking companies rationalised deliveries and improved route

planning, and airlines rationalised their networks and removed

excess weight from aircraft. Compressed or liquefied natural gas

became increasingly popular as a cheaper alternative fuel for

transit buses, refuse trucks and some trucking fleets. Railroad

operators revived long-dormant plans to convert locomotives to run

on a mix of gas and diesel, though none have yet made the change.

In retrospect, 2005 proved to be the peak year for oil

consumption in the United States and the other advanced economies.

U.S. consumption of motor gasoline, diesel, jet fuel and other

refined products declined by more than 2 million barrels per day,

almost 12 percent, between 2005 and 2013, even though the country’s

population increased by more than 20 million over the same period

and real output grew 10 percent. It was the biggest drop in fuel

demand in history and mirrored around the rest of the

industrialised world. On one estimate, the advanced economies’ fuel

consumption in 2013 was 8 million barrels below what would have

been predicted if the pre-2005 trend had continued. Since 2005,

fuel conservation has saved the equivalent of the entire exports of

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Saudi Arabia, the world’s largest oil exporter. Demand destruction

in the United States, Europe and Japan provided room for rapidly

developing economies in China, Southeast Asia, Latin America and

the Middle East to increase their own fuel consumption without

repeating the 2008 price spike. But in Asia, too, there were signs

in 2014 that consumption growth was slowing in response to the

pressure for greater efficiency and a general slowdown across the

region.

2.3.2 SHALE REVOLUTION

High prices did more than just restrain demand. They were the

catalyst for the shale boom in the United States which resulted in

the fastest growth in oil production in history during 2013 and

2014. The shale revolution stems from the successful application

of horizontal drilling and hydraulic fracturing techniques to

particularly dense and impermeable rock formations which proved

resistant to conventional vertical drilling. Neither technique was

new to the oil industry. The first horizontal well was drilled in

1929 and the idea of fracturing rock formations to stimulate oil

recovery has been around since 1860s. In the 19th century,

fracturing was done with dynamite, but the industry switched to

acid in 1930s, napalm in the 1940s and water mixed with chemicals

in the 1950s and 1960s. The problem has always been the relatively

high cost of horizontal drilling and fracturing treatments.

Horizontal drilling and fracturing was used extensively in North

Dakota’s Bakken shale in the early 1990s but could not be made to

work commercially and was abandoned by the end of the decade.

However, the quadrupling of oil prices between 2002 and 2012

-- coupled with significant technological improvements in downhole

steering, telemetry and logging while drilling -- created

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conditions for a second shale revolution, and this time it did not

stall. In 2005, fewer than 150 oil wells were drilled in the state

of North Dakota. But the number of new wells drilled soared to 850

by 2010 and more than 2,000 in 2013. Almost all the new wells were

drilled into the Bakken formation -- two layers of rich black

marine shale, which are found thousands of feet below the north-

western corner of the state as well as beneath parts of

neighbouring Montana and Saskatchewan. Production from the Bakken

surged from 2,500 b/d in 2005 to 250,000 b/d in 2010 and more than

750,000 b/d in 2013. By the end of 2014, Bakken output had reached

more than 1.1 million barrels per day.

Horizontal drilling and hydraulic fracturing to target oil

spread to Texas from around 2010, first to the Eagle Ford formation

in the southwest corner of the state, and then to the Permian Basin

in the west, which already had a long history of conventional oil

production. Smaller output increases have come from the

application of fracking techniques in Oklahoma, Colorado, Utah and

New Mexico. But Texas and North Dakota account for 95 percent of

the increase in U.S. oil output since 2008.

The result has been an extraordinary renaissance in U.S. oil

production. Output has surged from just 5 million b/d in 2008 to an

average of more than 8.5 million b/d in 2014 and now stands over 9

million b/d at the start of 2015. Production growth has been

accelerating as shale drillers become much more efficient at

locating wells and drilling and fracking them faster. Output

increased by 160,000 b/d in 2011, 850,000 b/d in 2012, 950,000 in

2013 and 1.2 million b/d in 2014, according to the U.S. Energy

Information Administration. Production increases were accelerating

right through the summer and early autumn of 2014 as shale firms

drilled a record number of super-productive wells into the Bakken,

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Eagle Ford and Permian Basin. Bakken production increased by an

extraordinary 260,000 barrels per day by October 2014 compared with

December 2013, while combined output from the Eagle Ford and

Permian Basin was up by another 400,000 b/d.

Elsewhere in the world, high prices also stimulated record

investment in exploration and production activities in new and more

challenging areas, ranging from the Caspian Sea and deep waters off

the coasts of Latin America and West Africa to the Arctic and East

Africa. So much extra oil has come from the shale plays and other

sources that oil prices continued to fall throughout the last three

months of 2014 and into the first weeks of 2015 even as Libyan

crude supplies were interrupted again.

2.3.3 SUPPLY DISRUPTIONS

By 2012 or 2013 at the latest it was apparent to careful

observers the global oil market was on an unsustainable trajectory:

stagnating fuel demand meeting rapidly increasing oil supply.

The only solution to the problem of incipient oversupply was a

sharp fall in prices, which had been trading over $100 per barrel,

to stem the rate of demand destruction and reduce the rate of

investment in new sources of production. But the need for lower

prices was masked by two factors. First, many observers doubted the

shale revolution could be sustained. Second, increased output from

wells in North America was offset almost exactly by the loss of

production across the Middle East and Africa as a result of war,

unrest and sanctions in Libya, Syria, South Sudan and Iran.

In its 2011 World Oil Outlook, OPEC expressed doubts about the

shale revolution’s sustainability and concluded “shale oil should

not be viewed as anything other than a source of marginal additions

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to crude oil supply.” The WOO went on: “Significant constraints

over the next ten years include: the need for geological analysis

of other shales; trained people to perform hydraulic fracturing;

and acquiring the horizontal drilling and fracturing equipment. In

the U.S. already, costs have accelerated sharply as the demand for

fracing equipment cannot be met.”

“Looking ahead, it is evident that output from new shale oil

deposits will not grow at a similar rate of 60,000 b/d per year as

the Bakken basin is presently,” OPEC concluded in what must be one

of the most spectacularly inaccurate forecasts of the shale boom.

But OPEC was not alone in being deeply sceptical about shale’s

sustainability. It was a position shared by many oil analysts and

non-shale producers. By 2013, and certainly by the start of 2014,

however, that position was no longer tenable, as shale production

continued to accelerate. OPEC’s 2012 World Oil Outlook acknowledged

“shale oil represents a large change to the supply picture” and the

scale of that shift has only become more obvious over the last two

years. With so much new oil coming from the U.S. shale plays, the

oil market relied on large supply disruptions from conventional

producers in the Middle East, North Africa and other parts of the

world, as well as continued demand growth from China, Southeast

Asia and the Middle East, to remain in balance. In fact, the oil

market needed ever increasing outages to offset the rapid growth in

shale production and maintain balance. Until the middle of 2014,

it seemed that unplanned outages might indeed increase by enough,

or even more than enough, to offset the continued rise in shale

production. Growing turmoil in the wake of the Arab revolutions

which started in 2011 had already almost eliminated Libyan oil

exports. With Islamist fighters surging across northern Iraq and

capturing the city of Mosul in June 2014 many oil experts became

21

alarmed at the threat to the country’s northern oil fields around

Kirkuk and Kurdistan, and potentially even the much larger fields

in the south of the country if Baghdad government could not stem

the advance. Some even began to worry about external or internal

threats to political stability and oil production in the Gulf

monarchies.

The perception of intensifying “geopolitical risks” to oil

supplies encouraged hedge funds and other speculators to amass a

record bullish position in crude-oil linked derivative contracts.

From late June onwards, it became increasingly clear that

geopolitical risks would not, after all, further interrupt the

supply of crude. Oil continued to flow from all parts of Iraq and

increase from Libya. Robbed of the last remaining source of

support, the incipient oversupply in the market became increasingly

obvious and a sharp price correction inevitable.

2.3.4 PRICE WAR BEGINS

Senior policymakers in Saudi Arabia appear to have grasped the

inevitability of lower prices faster than many investors.

Throughout September, October and November 2014, speculation

intensified about possible production cuts by OPEC members, led by

Saudi Arabia, to support prices. The Saudis themselves, however,

downplayed the prospect. In early October, senior Saudi officials

began to brief friendly analysts and traders not to expect

production cuts and indicated that the kingdom was prepared to

allow prices to slide. Cutting production to sustain prices at an

artificially high level would only sacrifice Saudi Arabia’s and

OPEC’s market share and allow shale production to continue

expanding. Instead, the kingdom determined to allow prices to fall

low enough to begin curbing the investment in new shale wells and 22

plays. Policymakers remembered bitter lessons from the early

1980s, when Saudi Arabia cut its own production and exports to prop

up prices in the face of falling demand and rising supplies from

non-OPEC suppliers including the North Sea, Mexico, China, the

United States and the Soviet Union.

In the end, the kingdom suffered a double hit to its revenues

from lower prices and lower output. Saudi policymakers are

determined not to make the same mistake again. On November 27,

2014, OPEC announced that its members would maintain their combined

production level at 30 million b/d. Brent crude prices, which had

already fallen to $77 per barrel by the time of the OPEC meeting,

dropped by another quarter to $59 over the next month as the market

digested the fact OPEC would not come to the rescue. The current

slump in oil prices is often portrayed as a straight fight between

Saudi Arabia and the North American shale drillers but the real

picture is more complicated. Shale has had such a disruptive impact

on the oil market because it has emerged right in the middle of the

cost curve. Breakeven prices for shale wells range from as low as

$30 per barrel to as much as $75 or more. Shale production is more

expensive than conventional fields on the Arabian peninsula. But it

is cheaper than some megaprojects like Kashagan in the Caspian Sea.

Its breakeven range overlaps with high-cost oil from stripper

wells, oil sands, heavy oil projects as well as ultra-deep water

and Arctic projects and aging fields like the North Sea. As a

result, Canada’s oil sands producers, North Sea firms, ultra-deep

water drillers, heavy-oil promoters and shale drillers outside

North America have all found themselves caught in the cross-fire

between Saudi Arabia and its closest OPEC allies on the one hand

and the U.S. shale entrepreneurs on the other.

2.3.5 PAINFUL ADJUSTMENT

23

Oil prices must ultimately drop to the point where the market

rebalances -- which means eliminating some of the previously

forecast production growth and slowing or reversing the loss of

demand. There are signs the adjustment is already well underway.

U.S. motorists have begun to buy bigger cars again as low prices

reduce the emphasis on miles per gallon in favour of space and

performance. Large and small oil companies have already slashed

tens of billions of dollars from their exploration and production

budgets for 2015 and 2016. In the shale patch, producers have

slashed drilling programmes for 2015 and started to idle rigs and

lay off crews. Between early October 2014 and January 9, 2015,

almost 190 rigs previously drilling for oil in the United States

were idled, around 12 percent of the total. In total, 550 rigs

could be deactivated in the coming months. It will take some time

for the slowdown in drilling to filter through to a slowdown in

supply growth because there is a large backlog of shale wells that

were drilled in 2014 but not yet completed. As these are put into

production, supply will continue to grow for a few months more.

But output from existing wells is not stable. After a burst of

very high production in the first few months after a well is

completed, output from shale wells tapers off rapidly as the

natural underground pressure is exhausted by the production of the

oil. Production from Bakken wells declines by as much as two-thirds

by the end of the first year. New wells must be constantly drilled

and fractured to replace the declining output from old ones. Unless

oil prices are high enough to cover the full costs of drilling and

fracturing a shale well, drilling will stop and output from the

shale plays will decline. Estimates for breakeven costs vary, but

many sources suggest oil prices have already fallen beneath the

threshold needed to sustain enough drilling to maintain current

24

levels of output. North Dakota’s state oil regulator has released

projections showing that output declining several hundred thousand

barrels per day by the middle of 2015, and even more in 2016,

unless prices recover from their current very low level. The

Energy Information Administration forecasts U.S. output will grow

by another 300,000 b/d to a peak of almost 9.5 million b/d in May

2015, then decline between June and September as the lack of new

drilling and the decline rates on all the wells leave production

falling. Beyond September, the EIA expects U.S. oil output to

start growing again but that is based on the assumption prices

recover to around $70 by the end of 2015 and edge up further in

2016, which is more than $20 per barrel above current levels.

Saudi Arabia and the United Arab Emirates have made clear they will

not cut their own production to push prices back up unless the

shale producers also restrain their output, and perhaps not even

then. The Gulf monarchies amassed large financial reserves during

the boom and are now indicating that they are prepared to run

budget deficits for a year or two to wait out the shale players.

What actually happens to production and prices in 2015 therefore

largely depends on the responses of the shale drillers – how far

they cut drilling and production rates, and how far they can

improve efficiency and cut costs to reduce the breakeven price for

new wells and sustain production in a lower price environment.

25

26

2.4 ANALYSTS ESTIMATE LOWER OIL PRICES AND IMPACT ON CRUDE

TANKERS

2.4.1 LOWER OIL PRICES

27

Lower crude oil prices imply lower profits for exploration and

production (or E&P) companies. The recent sharp drop in crude

prices has generated a lot of reevaluations of previous estimates,

not only for the price of crude but also on the stocks of the oil

E&P companies. The International Energy Agency further reduced its

forecasts for the global oil demand, cutting the daily demand by

230,000 barrels a day to 900,000 in 2015.

Crude tankers such as Tsakos Energy Navigation Ltd. (TNP), Nordic American Tanker Ltd.

(NAT), Teekay Tankers Ltd. (TNK), and Frontline Ltd. (FRO) as well as the Guggenheim

Shipping ETF(SEA) are a few that will be affected.

2.4.2 ANALYSTS’ ESTIMATES

The Sterne Agee Group estimates that companies will report

lower profits in 2014 and even lower in 2015. It dropped its per-

barrel price estimates for Brent crude from $92 in the fourth

quarter and $94 in 2015 and 2016 to new levels of $85 this quarter

and $86 in each of the next two years. Sterne Agee believes

sluggish oil prices will continue into the end of the year with

economic data of Europe and China creating volatility. Also, a lack

28

of communal activity to stem weakness in Brent crude from

influential OPEC (Organization of the Petroleum Exporting

Countries) members such as Saudi Arabia, Iran, and Iraq is another

point of concern. Sterne Agee’s analysts in its latest E&P industry

report estimated US production growth of 700,000 barrels per day.

2.5 GOLDMAN SACHS AND OTHER ESTIMATES

Analysts at Goldman Sachs foresee further declines in oil

prices with anticipated strengthening of the US dollar in 2015 and

weaker demand for commodities in China. A recent Bloomberg survey

indicates Brent sliding to $50 per barrel compared to $116 per

barrel in June. ANZ Research has slashed its 2015 oil-price

forecasts by nearly 25%. It expects NYMEX (New York Mercantile

Exchange) crude to average $68 a barrel and Brent crude to average

$71 a barrel next year.

2.6 IMPACT ON CRUDE TANKER COMPANIES

With industry analysts estimating a lower price range for oil

in the upcoming year, the crude tanker companies may benefit with

lower bunker fuel costs. Adopting the crude oil storage option, the

companies have thus managed to garner the increasing oil prices, if

any, in the future.

 FR

O

$2.3

3

-

$0.1

4

-

5.49

%NAT $11.

62

-

$0.1

1

-

0.94

%SEA $19.

36

-

$0.2

-

1.12

29

2 %TNK $5.4

7

-

$0.1

5

-

2.67

%TNP $8.2

0

$0.0

7

0.92

%

2.7 THE OIL PRICE CRASH OF 2014

Oil prices have fallen by half since late June. This is a

significant development for the oil industry and for the global

economy, though no one knows exactly how either the industry or the

economy will respond in the long run. Since it’s almost the end of

the year, perhaps this is a good time to stop and ask:

1. Why is this happening?

2. Who wins and who loses over the short term?, and

3. What will be the impacts on oil production in 2015?

1. Why is this happening?

Euan Mearns does a good job of explaining the oil price crash

here. Briefly, demand for oil is softening (notably in China,

Japan, and Europe) because economic growth is faltering. Meanwhile,

the US is importing less petroleum because domestic supplies are

increasing—almost entirely due to the frantic pace of drilling in

“tight” oil fields in North Dakota and Texas, using hydrofracturing

and horizontal drilling technologies—while demand has leveled off.

Usually when there is a mismatch between supply and demand in

the global crude market, it is up to Saudi Arabia—the world’s top

exporter—to ramp production up or down in order to stabilize

prices. But this time the Saudis have refused to cut back on

production and have instead unilaterally cut prices to customers in30

Asia, evidently because the Arabian royals want prices low. There

is speculation that the Saudis wish to punish Russia and Iran for

their involvement in Syria and Iraq. Low prices have the added

benefit (to Riyadh) of shaking at least some high-cost tight oil,

deepwater, and tar sands producers in North America out of the

market, thus enhancing Saudi market share.

The media frame this situation as an oil “glut,” but it’s

important to recall the bigger picture: world production of

conventional oil (excluding natural gas liquids, tar sands,

deepwater, and tight oil) stopped growing in 2005, and has actually

declined a bit since then. Nearly all supply growth has come from

more costly (and more environmentally ruinous) resources such as

tight oil and tar sands. Consequently, oil prices have been very

high during this period (with the exception of the deepest, darkest

months of the Great Recession). Even at their current depressed

level of $55 to $60, petroleum prices are still above the

International Energy Agency’s high-price scenario for this period

contained in forecasts issued a decade ago.

Part of the reason has to do with the fact that costs of

exploration and production within the industry have risen

dramatically (early this year Steve Kopits of the energy market

analytic firm Douglas-Westwood estimated that costs were rising at

nearly 11 percent annually).

In short, during this past decade the oil industry has entered

a new regime of steeper production costs, slower supply growth,

declining resource quality, and higher prices. That all-important

context is largely absent from most news stories about the price

plunge, but without it recent events are unintelligible. If the

current oil market can be characterized as being in a state of

31

“glut,” that simply means that at this moment, and at this price,

there are more willing sellers than buyers; it shouldn’t be taken

as a fundamental or long-term indication of resource abundance.

2. Who wins and loses, short-term?

Gail Tverberg does a great job of teasing apart the likely

consequences of the oil price slump here. For the US, there will be

some tangible benefits from falling gasoline prices: motorists now

have more money in their pockets to spend on Christmas gifts.

However, there are also perils to the price plunge, and the longer

prices remain low, the higher the risk. For the past five years,

tight oil and shale gas have been significant drivers of growth in

the American economy, adding $300 to 400 billion annually to GDP.

States with active shale plays have seen a significant increase of

jobs while the rest of the nation has merely sputtered along.

The shale boom seems to have resulted from a combination of

high petroleum prices and easy financing: with the Fed keeping

interest rates near zero, scores of small oil and gas companies

were able to take on enormous amounts of debt so as to pay for the

purchase of drilling leases, the rental of rigs, and the expensive

process of fracking. This was a tenuous business even in good

times, with many companies subsisting on re-sale of leases and

creative financing, while failing to show a clear profit on sales

of product. Now, if prices remain low, most of these companies will

cut back on drilling and some will disappear altogether.

The price rout is hitting Russia quicker and harder than

perhaps any other nation. That country is (in most months) the

world’s biggest producer, and oil and gas provide its main sources

of income. As a result of the price crash and US-imposed economic

sanctions, the ruble has cratered. Over the short term, Russia’s 32

oil and gas companies are somewhat cushioned from impact: they earn

high-value US dollars from sales of their products while paying

their expenses in rubles that have lost roughly half their value

(compared to the dollar) in the past five months. But for the

average Russian and for the national government, these are tough

times.

There is at least a possibility that the oil price crash has

important geopolitical significance. The US and Russia are engaged

in what can only be called low-level warfare over Ukraine: Moscow

resents what it sees as efforts to wrest that country from its

orbit and to surround Russia with NATO bases; Washington,

meanwhile, would like to alienate Europe from Russia, thereby

heading off long-term economic integration across Eurasia (which,

if it were to transpire, would undermine America’s “sole

superpower” status; see discussion here); Washington also sees

Russia’s annexation of Crimea as violating international accords.

Some argue that the oil price rout resulted from Washington talking

Saudi Arabia into flooding the market so as to hammer Russia’s

economy, thereby neutralizing Moscow’s resistance to NATO

encirclement (albeit at the price of short-term losses for the US

tight oil industry). Russia has recently cemented closer energy and

economic ties with China, perhaps partly in response; in view of

this latter development, the Saudis’ decision to sell oil to China

at a discount could be explained as yet another attempt by

Washington (via its OPEC proxy) to avert Eurasian economic

integration.

Other oil exporting nations with a high-price break-even point

—notably Venezuela and Iran, also on Washington’s enemies list—are

likewise experiencing the price crash as economic catastrophe. But

the pain is widely spread: Nigeria has had to redraw its government

33

budget for next year, and North Sea oil production is nearing a

point of collapse.

Events are unfolding very quickly, and economic and geopolitical

pressures are building. Historically, circumstances like these have

sometimes led to major open conflicts, though all-out war between

the US and Russia remains unthinkable due to the nuclear deterrents

that both nations possess.

If there are indeed elements of US-led geopolitical intrigue

at work here (and admittedly this is largely speculation), they

carry a serious risk of economic blowback: the oil price plunge

appears to be bursting the bubble in high-yield, energy-related

junk bonds that, along with rising oil production, helped fuel the

American economic “recovery,” and it could result not just in

layoffs throughout the energy industry but a contagion of fear in

the banking sector. Thus the ultimate consequences of the price

crash could include a global financial panic (John Michael Greer

makes that case persuasively and, as always, quite entertainingly),

though it is too soon to consider this as anything more than a

possibility.

3. What will be the impacts for oil production?

There’s actually some good news for the oil industry in all of

this: costs of production will almost certainly decline during the

next few months. Companies will cut expenses wherever they can

(watch out, middle-level managers!). As drilling rigs are idled,

rental costs for rigs will fall. Since the price of oil is an

ingredient in the price of just about everything else, cheaper oil

will reduce the costs of logistics and oil transport by rail and

tanker. Producers will defer investments. Companies will focus only

on the most productive, lowest-cost drilling locations, and this 34

will again lower averaged industry costs. In short order, the

industry will be advertising itself to investors as newly lean and

mean. But the main underlying reason production costs were rising

during the past decade—declining resource quality as older

conventional oil reservoirs dry up—hasn’t gone away. And those most

productive, lowest-cost drilling locations (also known as “sweet

spots”) are limited in size and number.

The industry is putting on a brave face, and for good reason.

Companies in the shale patch need to look profitable in order to

keep the value of their bonds from evaporating. Major oil companies

largely stayed clear of involvement in the tight oil boom;

nevertheless, low prices will force them to cut back on upstream

investment as well. Drilling will not cease; it will merely

contract (the number of new US oil and gas well permits issued in

November fell by 40 percent from the previous month). Many

companies have no choice but to continue pursuing projects to which

they are already financially committed, so we won’t see substantial

production declines for several months. Production from Canada’s

tar sands will probably continue at its current pace, but will not

expand since new projects will require an oil price at or higher

than the current level in order to break even.

As analysis by David Hughes of Post Carbon Institute shows,

even without the price crash production in the Bakken and Eagle

Ford plays would have been expected to peak and begin a sharp

decline within the next two or three years. The price crash can

only hasten that inevitable inflection point.

How much and how fast will world oil production fall? Euan

Mearns offers three scenarios; in the most likely of these (in his

opinion) world production capacity will contract by about two

35

million barrels per day over the next two years as a result of the

price collapse.

We may be witnessing one of history’s little ironies: the

historic commencement of an inevitable, overall, persistent decline

of world liquid fuels production may be ushered in not by

skyrocketing oil prices such as we saw in the 1970s or in 2008, but

by a price crash that at least some pundits are spinning as the

death of “peak oil.” Meanwhile, the economic and geopolitical

perils of the unfolding oil price rout make expectations of

business-as-usual for 2015 ring rather hollow.

36

SECTION THREE

3.0 WHAT ARE THE CAUSES OF THE SHARP DROP?

As for any storable commodity, underlying demand and supply

conditions for oil determine the long-run trend in prices, while in

the short-run movements in market sentiment and expectations (in

some cases driven by geopolitical developments and OPEC decisions)

exert an influence too. Prices may respond rapidly to surprises in

the news even before actual changes occur. In 2014, relevant events

included geopolitical conflicts in some oil -producing regions,

OPEC announcements, and the appreciation of the U.S. dollar. Long-

term developments in supply and demand have also played important

roles in driving the recent decline in oil prices.

Trends in supply and demand. Recent developments in global oil

markets have occurred against a long-term trend of greater-

than-anticipated supply and less-than-anticipated demand.

Since 2011, U.S. shale oil production has persistently

surprised on the upside, by some 0.9 million barrels per day

(mb/d, about 1 percent of global supply) in 2014. Expectations

of global oil demand have been revised downwards on several

occasions during the same period as economic growth

disappointed. Between July and December 2014 alone, the

projected oil demand for 2015 has been revised downwards by

0.8 mb/d (IEA, 2014a and 2014b). Global growth in 2015 is

expected to remain much weaker than it was during the 2003-08

period when oil prices rose substantially. Further, the oil-

intensity of global GDP has almost halved since the 1970s as a

result of increasing energy efficiency and declining oil-

intensity of energy consumption.

37

Changes in OPEC objectives. Saudi Arabia has traditionally

acted as the cartel’s swing producer, often using its spare

capacity to either increase or reduce OPEC’s oil supply and

stabilize prices within a desired band. This changed

dramatically in late November 2014 after OPEC failed to agree

on production cuts. The OPEC decision to maintain its

production level of 30 mb/d signaled a significant change in

the cartel’s policy objectives from targeting an oil price

band to maintaining market share.

Receding geopolitical concerns about supply disruptions. In

the second half of 2014, it became apparent that supply

disruptions from conflict in the Middle East had unwound, or

did not materialize as expected. In Libya, despite the

internal conflict, production recovered by 0.5 million barrels

per day (about ½ percent of global production) in the third

quarter of 2014. In Iraq, as the advance of ISIS stalled, it

became apparent that oil output could be maintained. In

addition, the sanctions and counter-sanctions imposed after

June 2014 as a result of the conflict in Ukraine have had

little effect on oil and natural gas markets thus far.

U.S. dollar appreciation. In the second half of 2014, the U.S.

dollar appreciated by 10 percent against major currencies in

trade-weighted nominal terms. A U.S. dollar appreciation tends

to have a negative impact on the price of oil as demand can

decline in countries that experience an erosion in the

purchasing power of their currencies. Empirical estimates of

the size of the U.S. dollar effect cover a wide range: the

high estimates suggest that a 10 percent appreciation is

associated with a decline of about 10 percent in the oil

price, whereas the low estimates suggest 3 percent or less.

38

Although the exact contribution of each of these factors

cannot be quantified with precision, it is clear that the dominant

factor in the price fall has been changes in supply conditions,

stemming from the expansion of oil output in the United States,

receding concerns on supply disruptions, and OPEC’s switch to a

policy of maintaining market share.

3.1 DECLINING OIL PRICES IMPACT ON GLOBAL LOGISTICS INDUSTRY

The decline in oil prices over the past 12 months has had a

major impact on most sectors of the global logistics industry in

terms of cost base, according to Thomas Cullen of Transport

Intelligence (Ti). Measured in real terms the oil price had hit

highs comparable to the 1979 oil price spike. In part this has been

driven by a weakening demand in the Chinese economy and a

levelling-off of demand in the developed world, not just for

cyclical reasons but also because economies have become more energy

efficient, said Cullen. In addition alternative sources of supply,

such as North American tight oil, have reduced reliance on the

Middle East oil producing countries. “This ought to be great news

for a sector such as logistics which is so heavily exposed to oil

prices. In theory margins should rise as prices fall. However it

may not be quite as straight forward as this,” said Cullen.

Cullen noted that a fuel intensive sector such as air freight

should see better returns for airlines. This assumes however that

the capacity picture is not complicated by older, less efficient

aircraft re-entering the market. Container shipping these days is

less affected by the bunker fuel price, having more than halved its

consumption of fuel per container through the use of bigger ships

and slow steaming strategies. Consequently it is likely that lower

fuel prices will have an effect, but probably not a transformative

39

one, said Cullen. In the express sector, traditionally the likes of

FedEx and UPS have benefited from falling fuel prices as the fuel

surcharge they impose lags behind the price of jet fuel. Impact on

contract logistics is likely to be more marginal as in many

contracts the price of fuel is passed on directly to the customer.

However the implications for the logistics sector go beyond that of

the fuel price change. Regional and global demand is likely to feel

the impact as well. Cullen said the Middle Eastern demand for both

air freight and sea freight has been consistently high after it

recovered from the initial shock of the economic crash in 2009.

Russia has been more volatile but has also seen underlying growth.

However that growth has slowed significantly over the past few

months, driven as much by political factors as the falling oil

price. The IATA numbers already reflecting such a slowdown on the

European air freight sector, said Cullen.

3.2 HOW DOES THE FAST FALL IN OIL PRICES IMPACT THE

MARITIME INDUSTRY?

The fall in oil price has had several impacts on the shipping

sector; to understand them one has to look at the nature of

transportation. The demand for transportation occurs if goods are

shipped around the world. This happens in a globalized world when

goods are produced in one part of the world but mainly consumed in

another. Transportation ensures the goods are shipped where they

are consumed. In the current world, many consumer goods – shipped

in containers – are consumed in Europe and the Americas with Asia

being the workbench producing many of those goods. Indeed the

largest trade routes of container ships are Asia-Europe route and

the transpacific routes. When we look at economic indicators

predicting economic activity in Europe and the Americas, the

40

picture looks at least stable; this is supported by the low oil

prices

Europe

In the EU, economic recovery will be constrained by high

unemployment and weak consumer confidence, but a positive stimulus

from lower fuel prices will help to sustain gradual economic

recovery. Overall EU GDP growth is forecasted to improve from 1.3%

in 2014 to 1.7% in 2015, supported by the European Central Bank’s

continued quantitative easing policies and the stimulus from very

low oil prices and the markedly weaker Euro. The growth in North

America seems to be stable, with an upwards direction – this is

supported by all main indices.

3.3 HOW WILL OIL PRICE DROP INFLUENCE NAMIBIA’S SHIP REPAIR

INDUSTRY?

Burgeoning West African offshore oil and gas industry has had

a significant impact on Namibia, and specifically Walvis Bay.

Between Africa’s top two oil producing countries Nigeria and

Angola, placed 13th and 15th as global oil producers respectively,

there are currently about 322 offshore support vessels and 68 oil

rigs. On average for each oil rig operating, up to 6 support

vessels are required. According to Hannes Uys, CEO of ship

repair company Elgin Brown & Hamer (EBH) Namibia, oil price drop

has seen a reduction in the utilisation rates of rigs and OSV’s by

11% and 8 % respectively.

“For Namibia and its ship repair industry, there are very

real risks in the wake of the current economic crisis which oil

producing countries find themselves in, as a result of the

sustained low price of crude oil. The questions remain, how serious

are these risks, and how do we, as a country and an industry, 41

safeguard ourselves against them?” Uys urged those in the ship

repair industry not to be complacent, and to join forces against a

common threat. “We need to entrench, on a wider scale, a culture

of high-performance and discipline, and in order to do this, we

have to become more efficient, even aggressively so,” he said.

“This is undoubtedly a crisis period. It is imperative that our

affected clients, including the offshore supply vessel (OSV)

owners, feel that the industry is being backed by our government

and other industry stakeholders, and that we are seen to be taking

serious, urgent and significant steps to accommodate them over this

24 month period,” Uys adds.

3.4 IMPACT OF FALLING OIL PRICES ON LNG

The recent surprise drop in crude oil prices is having big

impacts on international LNG prices and may cause a slowdown in the

development of LNG export plants globally. LNG is liquefied natural

gas, cooled to a temperature of -260° F, for the purpose of

compression and transportation. International shipments of LNG by

container ship are generally price-indexed to crude oil, meaning

that falling oil prices have led to a comparable drop in LNG

prices.

Demand for LNG in Asia has been soft due to mild weather this

winter, contributing to the slide in prices. 75% of global LNG

demand is in Asia with the bulk of the cargoes going to Japan,

followed by South Korea and then China, India and Taiwan. In South

Korea, 2014 imports were down nine per cent year-on-year. Slowing

gas demand growth has also led to concerns that China will

struggle to absorb contracted LNG, volumes of which will double

over the next three years. Supply of LNG in the Pacific basin has

42

grown substantially in recent years, leading to an oversupplied

market.

Prices for LNG in Japan hit $10.069 per million Btu (MMBtu) on

December 15, having fallen from around $16 at the start of 2014. As

LNG contract prices are typically based on the average of the

preceding six to nine months, it will be mid-2015 before suppliers

feel the full effects of lower oil prices on their cash flow. The

LNG price decline came in two stages. Prices dropped in the summer,

as new supply from ExxonMobil’s Papua New Guinea (PNG LNG) project

hit the market. Prices then fell further as Brent oil dropped from

$110/bbl in August, to below $60/bbl in December. When Brent crude

sells for $100, oil-linked natural gas contracts typically

translate to around $14 MMBtu, giving U.S. LNG a big price

advantage. This advantage disappears as crude prices fall, with

crude at $60 LNG indexes to $8.40 per MMBtu. U.S. LNG producers

have been targeting prices of $11 or $12 per MMBtu to be profitable

after absorbing the costs of buying the gas, liquefying it,

shipping it around the globe and regasifying it. 

When crude oil prices dropped below $80 per barrel, LNG from

the US became less competitive in Asia compared to plentiful gas

from Australia and Qatar. Falling oil prices have the effect of

increasing competition from oil. Price action in Asia may lead to

more gas being diverted to Europe and South America, where U.S. gas

may find a niche. Such a shift also could reshape European gas

markets by lowering prices and squeezing out some Russian pipeline

gas. Many countries have entered the LNG export trade in the last

decade, contributing to a crowded market. Egypt began shipping LNG

in 2005, Equatorial Guinea and Norway in 2007, Russia and Yemen in

2009, Peru in 2010, Angola in 2013 and Papua New Guinea in 2014.

Australia has also greatly increased its export capacity and

43

expects to overtake Qatar as the world export leader. Major project

proposals are also in the works in Russia, Canada and East Africa,

all of which contribute to a well-supplied international market.

The US today has issued permits for four LNG export terminals, in

addition to the existing Kenai terminal in Alaska. A dozen or more

applications are in process at FERC, but only a few more are

expected to be given permits. Projects that have not received FIDs

(Final Investment Decisions) have uncertain futures, both in the US

and globally. A number of proposed projects in Australia have been

shelved and greenfield projects in Canada have been challenged as

well due to high costs.

With projects under construction going ahead as companies

treat them as sunk costs, Australia’s LNG export capacity is set to

more than triple to 86 million tonnes a year before 2020, putting

it ahead of current leader Qatar which exports 77 million tonnes

annually and U.S. expectations of selling 61.5 million tonnes per

year by 2020. Even though the U.S. has only ever had minimal LNG

exports, US LNG suppliers have been seen as attractive to Asian

buyers due to the perception of the U.S. offering very secure

supply, with firm contract commitments. Adding to the interest in

U.S. supplies have been efforts in recent years to index U.S. LNG

to Henry Hub prices rather than crude oil prices. Asian buyers were

seeking to break away from expensive oil linked contracts and take

advantage of inexpensive U.S. gas prices, but now with crude oil

prices in a free fall, buyers are backing away from changing the

formula for now. LNG suppliers will be hoping for a cold 2015, but

the background of a low oil price environment will place

pressure on LNG prices in the near term. However, long-term growth

prospects remain compelling due to demand expectations.

44

3.5 LOW OIL PRICE MEANS GREATER DEMAND FOR CHINA EXPORTS,

BANK SAYS

Chinese container volume growth has stabilised and Barclays expects it to accelerate this

year.

The falling oil price is having a talismanic effect on the

cargo shipping industry, boosting consumer spending, raising U.S.

demand for China imports and improving the profitability of

container lines, research from Barclays has found. In a paper to

customers, the bank said it had increased its container volume

growth forecast by almost 1 full percent to 5.4 percent for 2015

because of the positive impact of lower oil prices. The raised

growth expectations extend into 2016 and 2017 when the bank expects

a 5.2 percent year-over-year improvement in demand. Even as

container lines struggle to adjust schedules to cope with the

chronic U.S. West Coast Port congestion, Barclays had good news in

an area that has for the last few years been elusive for many

carriers — profitability. The bank found the recent decline in fuel

costs was not completely reflected in recent container shipping

freight rates, which implied there was potential for improving the

profitability of container shipping lines.

45

Trans-Pacific spot freight rates have struggled to hold on to

any gains, despite a host of general rate increases during 2014.

Carriers are trying desperately to push up rates in the run up to

contract negotiations with customers that begin in the second

quarter, but have found a market with little inclination to pay

more. However, using 2013 as the base year equal to zero, the bank

calculated the changes in profitability that could be derived from

spot freight rates and spot crude oil prices. It concluded that

there appeared to be a substantial up-tick in implied industry

profitability in the fourth quarter of 2014 and into January,

especially on the trans-Pacific trade lane. “Given the general

over-supply and sophisticated commercial client base, we would

expect customers to demand savings pass-through quickly. However,

given the rapid decline in fuel prices in second half 2014, we do

expect strong results in the fourth quarter for Asia ex-Japan

container shipping companies under our coverage,” the Barclays

report noted. Some of the results are in, and there was a definite

improvement in the last quarter. For instance, despite Neptune

Orient Line’s container division APL recording a before tax loss of

$37 million in the fourth quarter, it was still an improvement

compared to the same quarter last year. The low fuel price enabled

the line to slash its operating costs, although NOL group CEO Ng

Yat Chung said there was no certainty about how long the benefits

of cheaper fuel would last.

“While we are seeing some benefits from the current trend of

lower bunker prices, the longer term impact of the drop in fuel

price on container freight rates is uncertain,” he said in a

statement. Barclays ran a sensitivity analysis to assess the

effects that changes in the price of fuel would have on Chinese

exports, and the results were compelling. From January through

46

September, Brent crude oil prices averaged $110 per barrel before

plunging to around the $40 level. For this year, Barclays predicts

oil will average $44 per barrel. According to the bank’s

sensitivity analysis, that implies a potential increase in China’s

exports to the U.S. of almost 2 percent. “We expect a potential

positive impact of lower oil prices on trade volumes due to higher

discretionary consumer income. For example, the Barclays U.S.

Equities Research team estimates that a 20 percent decline in fuel

prices could increase U.S. consumption by $70 billion,” the bank

report stated. For every $10 decline in the oil price per barrel,

there will be an additional $1.1 billion of consumer spending on

Chinese exports. “We use the U.S. as an illustration, but the

conclusion of lower oil prices lifting Chinese exports can be

generalised to most regions,” the bank said.

3.6 LOWER OIL PRICE SEES MASSIVE SAVINGS FOR GLOBAL SHIPPING

COMPANIES

Falling oil prices are significantly benefiting shipping lines

in the short-term, enabling them to pay down some of the red ink

accumulated over the last five years, but executives are concerned

that the lower price of fuel could be a harbinger of a wider

economic slowdown. Cheaper oil, and hence cheaper marine bunker

fuel, is saving the global shipping industry about US $100-million

every day, according to analysts at BIMCO, the largest trade

association for shipping companies in the world. BIMCO forecasts

that if the trend continues, with Brent crude remaining at US $86

per barrel or lower and the bunker price around US $460 a tonne,

shipping lines will see earnings improve significantly in the

fourth quarter. Bunkering costs generally accounts for 20 to 30% of

the total operational costs for container lines, with the lower

47

fuel price for large container ships equating to a 10% drop in

costs per container.

As a result, China Cosco, which owns the world’s fifth-largest

container ship fleet, reported a 12% operating margin in the third

quarter, up from 4% in the same period last year. China Shipping

subsidiary, China Shipping Container Lines, the world’s seventh-

largest container carrier, recorded a 6% operating margin in the

third quarter, compared with negative 2% in the same period last

year. As result of these financial results and analysts’ optimistic

forecasts, the Baltic Dry Index, a benchmark for dry commodity

freight cost, has gained more than 50% to 1,424 since the middle of

last month. However, at a macro-level, if the oil price remains low

for a prolonged period – a usual indicator of sluggish economic

growth – shipping lines will feel even greater pressure than those

over the last year or so, as a slowdown in the global economy

impacts international trade. “Normally declining oil price means

[slower economic growth, therefore] less demand for shipping.

However, we haven’t seen such correlation this time,” said Tor

Svensen at DNV GL, the world’s largest ship classification society,

which also provides technical advice to the oil and gas industries.

“Personally I don’t believe the current decline is long-lived. It

probably will not last for more than half a year.”

Source: Big News Network

3.7 MOODY'S EXAMINES IMPACT OF LOW OIL PRICES ON VARIOUS

INDUSTRIES WORLDWIDE; ADJUSTS OIL PRICE ASSUMPTIONS

New York, January 15, 2015 -- Tumbling oil prices have led

Moody's Investors Service to lower its pricing assumptions for the

two benchmark crude oils, European Brent and West Texas

Intermediate (WTI), the rating agency said today in a new report

48

that also looks at how a sustained period of lower oil prices would

affect numerous industries around the world. Industries for which

fuel is a direct and significant cost will see a positive effect

from lower oil prices, as will consumer-dependent businesses more

generally, since lower gasoline prices mean consumers will have

more cash to spend on other items. But oil and gas exploration and

production companies, and the companies that supply them, will be

hurt by lower crude prices, according to the report, "Global

Corporate Finance: Airlines, Packaged Food, Shipping Get Biggest

Lift from Oil Price Plunge" Moody's revised its assumptions for

average spot prices for Brent crude to $55 per barrel through 2015,

to $65 per barrel in 2016 and to $80 in the medium term, and for

WTI crude to $52 per barrel in 2015, to $62 per barrel in 2016 and

to $75 in the medium term. "At the start of 2015, crude prices of

about $50 per barrel reflected factors including growing non-OPEC

supply, supply outpacing demand worldwide and Saudi Arabia's

decision not to keep acting as OPEC's swing producer," says

Managing Director, Steve Wood. "While we see no catalysts that

would change the supply-demand equation in the near term, our long-

term oil price assumptions reflect our view that prices will

eventually rebound." --Positive impact for many non-financial, non-

energy industries, but bad news for others-- Airlines, shipping and

packaged foods are among the business sectors that will benefit

most from lower oil prices, while the oil exploration and

production and oilfield services sectors will bear the brunt of the

collapse.

"Passenger airlines' financial performance will improve in

2015 as a result of lower fuel costs," says a Moody's vice

president, Jonathan Root. "American Airlines should realize the

maximum benefit, but Delta, United, Lufthansa and Air Canada will

49

also be among those that gain." Conversely, the suppliers of

aircraft and components could suffer as falling prices increase the

risk of order cancellations and deferrals down the supply chain.

"Oil prices have fallen to a level that significantly reduces the

operating cost benefits airline customers will realize from new

fuel-efficient aircraft on order compared to when orders were

placed, when Brent crude averaged more than $80 a barrel," says a

Moody's senior vice president, Russell Solomon. "As a result, we

expect order deferrals and cancellations to increase beyond the

bump that has recently been anecdotally noted." Sustained lower

prices will also boost the margins of processed food manufacturers

such as Nestlé, Mondelez International and Kraft Foods, which spend

10%-15% of the cost of goods on freight and fuel. These companies

should also see sales increase as cheaper oil leads consumers to

spend their extra cash on discretionary food items. Restaurants

will likely benefit for the same reason, though not as

dramatically, with quick-service outlets such as McDonald's and

Wendy's benefiting from lower-income consumers, who tend to see the

biggest increase in their disposable income when gas prices are

low. Falling oil prices will be modestly positive for automobile

makers, Moody's says. In North America, demand will shift toward

larger, higher-margin vehicles such as SUVs at the expense of

smaller, more fuel-efficient models. Sales should improve for

companies including General Motors and Ford. But sales aren't

likely to improve much in the saturated Japanese market, and since

motorists there don't drive as much on a daily basis as they do in

the US, they are less likely to shift to larger cars. Additionally,

high taxes in both Japan and Europe are likely to blunt the impact

of cheaper crude on car sales.

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3.8 FALLING OIL PRICES IMPACT OSV MARKET

After several successive years of strong growth, owners and

managers in the offshore supply vessel (OSV) segment are looking at

2015 with some trepidation. The recent oil price slide has focused

thoughts on exploration and production costs, with some voicing

concerns about the influence this will have on primary OSV market

drivers. Demand for platform supply vessels (PSVs) and anchor-

handling tug supply (AHTS) vessels mainly derives from drilling

activity, field development work, and production facility support.

The oil price drop towards a low of $70/barrel has sparked fears

over the health of these demand drivers in the next 12 months. But

it would be wrong to view the global OSV market as a homogeneous

block and link a slide in the oil price with any certainty with

lower demand for vessels in any given market. Different regions and

vessel classes will offer different opportunities. The age of a

vessel, its technical specifications, and even flag state will play

a role in its demand and utilisation this year. Previous oil price

slides have had minimal influence on the upward drive in OSV term

demand. Forecasts for rig demand and new field development projects

continue to show growth in the coming 12 months. The latest

analysis from the IHS Global Supply Vessel Forecast continues to

show growth in overall term demand for OSVs in 2015, but this

growth is focused on certain vessel classes in specific regions and

is often seasonal by nature. In the PSV segment, the number of

vessels exceeding 4,000dwt on term contracts in 2015 is expected to

be 5% higher than in 2014. The second and third quarters offer the

best conditions for larger PSVs, as the North Sea summer will help

increase the number of term contracts. In addition, demand for

large PSVs to work in US Gulf of Mexico waters is expected to

increase, while activity in Latin America will hold firm. In the

51

AHTS market, vessels of 15,000–22,999bhp could see a boost in

demand from the increased use of floating production units in

certain regions, with activity during both the hook-up and

installation stages, and the continuing production stage.

However, these market segments will be harmed by recent

cancellations of drilling support contracts in Russian waters, as

tensions continue between the Kremlin and the West. Growth in

demand is not limited to the more powerful vessels, as contracts

for AHTS of 6,000-9,999bhp are also expected to show positive

movement in 2015. Capable of both routine supply duties and

undertaking anchor handling activities, these vessels are often

seen as the workhorses of the fleet in regions of shallow water and

a benign environment. Day rates for vessels of this size are lower

than for the largest vessels and this will boost demand in an

increasingly cost-conscious business climate. The positive message

of increased term demand needs to be balanced against the backdrop

of continued fleet expansion. The current newbuilding orderbook

exceeds 570 vessels, more than 400 of which are scheduled for

delivery before the end of this year. Many of these delivery dates

will slide, and some vessels on order but not yet being built will

be cancelled, but a fleet increase close to the 220 vessels

delivered across 2014 should be expected. Most of this fleet growth

is focused on large PSVs, adding more competition to the market

segment showing the most positive demand growth. The overall effect

on the market will be to restrain improvements in usage and day

rates. Vessel age has begun to play a major role in term contract

requirements, with many offshore oil and gas operators stipulating

vessels must be less than 15 years old. This trend is increasing

worldwide, including in markets such as Mexico and the Middle East,

where previously vessel age was of little concern. Term utilisation

52

for OSVs built before 1991 is today about 30% in both the AHTS and

PSV markets and declined in 2014, a trend seen since the start of

2008.

This slide in vessel utilization highlights the need to remove

older tonnage. Examples of scrapping and sales out of the offshore

market were reported with greater frequency in late 2014, so a more

concerted move to address the issue of older vessels may feature in

2015. The diversity of the OSV market prevents the making of a

simple forecast for 2015. There will be winners and losers in each

region, vessel type, and vessel class. Yet threats and concerns are

the same across the industry: oversupply, older tonnage, and

weakening day rates. These are the same concerns faced at the start

of 2014. However, a sliding oil price, with the subsequent

potential for a cut in offshore budgets, is shining a harsher light

on these worries.

53

SECTION FOUR

4.0 PLUMMETING OIL PRICES AND ITS IMPACT ON THE SHIPPING INDUSTRY

The official OPEC website defines itself as “ a permanent

intergovernmental organization of 12 oil-exporting developing

nations that coordinates and unifies the petroleum policies of its

Member Countries and ensures the stabilization of oil markets in

order to secure an efficient, economic and regular supply of

petroleum to consumers, a steady income to producers and a fair

return on capital for those investing in the petroleum industry.”

In layman terms, OPEC is simply a Cartel of twelve member countries

(Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria,

Qatar, Saudi Arabia, the United Arab Emirates and Venezuela) which

controls oil prices. For lack of a better term, think of it as a

group which controls the movement of oil thereby giving it

tremendous clout in fixing oil prices. For eg. If OPEC decides to

increase production, the price of crude oil will drop owing to

oversupply in the market. On the contrary, if OPEC decides to cut

production, the prices will spike up. OPEC has such significant

impact on the shipping industry that Lloyd’s List recently named it

as the third most influential factor in Shipping led only by the

Chinese Premiere and the Maersk Group CEO. As with any big

organisation, OPEC is dominated by its most powerful and

influential member – the one which has maximum oil resources. No

prizes for guessing this one – it is none other than the Kingdom of

Saudi Arabia. It is interesting to note here that OPEC also

includes the Islamic Republic of Iran, the Kingdom’s biggest rival

both ideologically and in terms of oil wealth.

Now let’s briefly talk about Shale Oil. Shale Oil is a

relatively new discovery which is produced by a process called 54

fracking (blasting underground rocks with a mixture of water,

chemicals and sand). The Shale Boom is being spearheaded by Saudi

Arabia’s long-time friend and ally The United States of America.

The potential for Shale Oil is so much that America has now

surpassed Saudi and Russia to become the biggest producer of Oil.

However, there is one catch in Shale Oil. It takes significantly

more money to extract one barrel of Shale Oil than it takes to

extract one barrel of conventional crude oil. To give you an

example, Saudi Arabia requires about 5-8 USD to extract one barrel

of Crude Oil. But it takes more than USD 25 to extract one barrel

of Shale Oil. Now armed with this background information, let’s try

to understand the probable causes for this continued drop in Crude

Oil Prices

1. Geopolitics: Two of Saudi Arabia’s biggest rivals are Russia

and Iran. The economy of both these countries almost entirely

depends on oil revenue. With the regime change in Iran, the

Americans and the rest of the western countries are indicating

a thaw in their relationship with Iran. There is every

indication that the embargo and sanctions on Iran will be

lifted soon. The Saudis see Iran as having significantly more

influence in the Persian Gulf region in recent years than it

used to. The ISIS conflict in the region has only helped Iran

to become a key regional player. The Saudis will do whatever

it takes to thwart Iran in its tracks and maintain its

regional dominance. Crippling Iran’s economy is the best way

to do it without a military conflict. On the other hand, the

Russians are already reeling under heavy economic sanctions

imposed on them following the Ukraine crisis. The Saudis feel

that this is the perfect opportunity to strike a body blow.

This is the reason that the Saudi controlled OPEC has

55

steadfastly refused to cut down production which could have

pushed oil prices higher up. Now one might wonder how Saudi

Arabia is going to sustain such low oil prices themselves.

After all, the kingdom’s economy is also almost entirely

dependent on oil revenue. However, the Saudis can easily

sustain these prices at least for the next few years. They

have upwards of 900 Billion USD in reserves. The Saudi Oil

Minister Ali al-Naimi recently, rather crudely, boasted that

the kingdom wouldn’t let OPEC cut down production even if the

oil prices fell to 20 USD. All this just goes to show the

Saudi resolve in riding out the storm at the expense of other

key players.

2. Shale Oil: As discussed earlier, the Americans are the biggest

producers of Shale Oil. America has far more sources of Shale

Rocks than any other country. So much so, that it is believed

that America might completely stop importing oil in the near

future. However, they have one big problem with Shale Oil.

Extracting Shale Oil is a relatively complicated process and

the resulting cost of producing Shale Oil is significantly

higher than conventional oil. So the American Oil Men have to

rely on banks to lend them money which is used to extract this

oil. The banks in turn hedge this lending risk on the price of

conventional oil. So if the price of Crude Oil drops, lending

the money becomes riskier for the banks. As a result, banks

stop lending, thereby crippling the Shale Oil production. The

Saudis are trying to nip the Shale Boom in the bud before it

threatens their energy hegemony. They want to squeeze out all

the American oil men who are investing in Shale energy.

3. Weak Economy: The demand for oil hasn’t been at a rate which

was projected after the world economies started to recover.

Europe’s revival is still in doubt following Greece’s change

56

of government. Some of the developed countries are moving

towards greener energy. And although there is no indication of

a cool down of the Asian powerhouses, India and China are not

consuming as much oil as was earlier projected. All major

hoarders are treading cautiously fearing a meltdown similar to

the recent one. All this has produced an oversupply in the

market, pushing prices down.

4.1 IMPACT ON THE SHIPPING / TANKER INDUSTRY

Now let’s briefly discuss how such low prices would impact the

Shipping Industry.

1. Bunker Prices: The biggest component of money required to run

a ship is spent on bunker fuel. Even a couple of tons of fuel

saved each day will have a significant impact on the bottom-

line of a shipping company. So imagine how much a shipping

company is now saving with the bunker prices more than halved.

To put things in perspective, here is a list of Bunker Prices in

the top four bunker ports in the world as on Feb 2nd 2015.

Port IFO380Singapore 289.00Rotterdam 246.00Houston 269.50Fujairah 293.00

Above prices for Bunker Fuel IFO 380 grade are in USD / Ton. Source

: Bunkerworld.

Just over a year ago, the average prices of Bunker fuel was

more than 650 USD / Ton. Without a doubt, these are massive savings

for shipping companies.

57

More Savings = More Profits

More Profits = Higher Salaries / More New Buildings / More Job

Opportunities

2. Higher Freight: Those Tankers which were “awaiting orders” off

Fujairah have all disappeared. No longer do you see vessels

“super slow steaming” as often as you used to. When the prices

of oil change, there is bound to be an increase in the

movement of cargo. With the oil prices dropping, the dormant

tanker industry has suddenly come to life.

Investors, Speculators and Traders have all been busy buying

and selling oil. A loaded passage is the business end of the voyage

for a tanker vessel. The increased movement of cargo has resulted

in higher freight rates. The Ship Operators are now in a demanding

position and calling the shots.

Again,

Higher Freight Rates = Higher Profits

Higher Profits = Higher Salaries / More New Buildings / More Job

Opportunities

3. Consolidation of Positions: With shipping companies

shoring up their bottom lines and revenues, the next step is to

increase productivity. In the shipping world, this is achieved by

buying more vessels and upgrading the existing fleet. Higher

revenues from low bunker prices and higher freight rates have

enabled shipping companies to divert significant funds for purchase

of new buildings and second-hand vessels. There is fervent buying

and selling activity in the Sale and Purchase segment of the

business. Companies are positioning themselves for maximum impact

58

and to consolidate existing positions. Helped by low bunker costs

and high freight rates, the purchase of VLCCs by Euronav has seen

the company’s profits reach record levels. It has also enabled it

to become one of the leading VLCC operators in the world from being

a relatively unheard of company less than a year back. Likewise,

Maersk Tankers has positioned itself as a specialist Product Tanker

company betting on clean – refined products over dirty petroleum

oils. In the years to come, such strategic decisions done in the

current healthy market will prove to be the foundation for a solid

future. Several other operators such as Teekay, Shell and Frontline

are making efforts to consolidate positions and carve out a niche

for themselves in the vast industry.

4. Expect More Storage Tankers: This has already been set in

motion. Several traders are chartering tanker vessels for long

term storage in the hope that oil prices will spike soon and

they will make a profit on the oil which was purchased at low

levels. If you are someone sailing on tanker vessels, there is

a likelihood that you might have to join one of such vessels

soon. So be prepared for those long and boring anchor watches.

Oil is not called the Black Gold for nothing. Petroleum

politics has always dominated the Middle Eastern polity and has

rightly been the subject of many epic movies (There will be Blood,

The World is not Enough, Syriana, etc). There have been innumerable

allegations and counter allegations about the use and abuse of

petrodollars. No matter how many alternate energy sources are

discovered, it is undeniable that oil will continue to remain the

primary source of energy for at least several more decades to come.

There is absolutely no doubt that the current drop in oil prices is

only a short term phenomenon and we will soon be discussing the

reason for the sudden spike in oil prices. Until then, let’s just

59

relax and not lose sleep over the car’s mileage or in us seafarer’s

case – the darn bunker consumption.

4.2 RAILWAYS REDUCE SHIPPING LOAD ON DROP IN OIL PRICES

The collapse in oil prices that has hammered producer profits

is also casting doubt on the business case for moving crude by

rail. Railways are reducing their expected oil volumes after a 56-

per-cent plunge in the benchmark price of crude since the summer

that has consumed the profit margins crude producers and shippers

once enjoyed. The cost of shipping a barrel of oil by train can be

as much as $22 (U.S.), depending on the destination, double that of

pipelines and often exceeding the profits traders count on by

buying oil in Alberta and selling it for a higher price to a

refinery on the U.S. East Coast or Gulf Coast. Some industry groups

say crude-by-rail volumes are still expected to climb sharply. The

Canadian Association of Petroleum Producers (CAPP) has estimated

the amount of Canadian oil moving by rail could reach 700,000

barrels a day by 2016, from about 200,000 today, as oil sands

projects near completion and wells drilled last year begin

producing. But the forecast, made last June, could prove

aggressive, given the recent big cuts to oil producers’ budgets,

which will restrain future production growth.

And it is unclear if high costs make shipping by rail a money-

making mode of transport for producers. “That’s the real question.

We haven’t seen anybody as of yet shut any production as a result

of that, so that means they’re making some [money] but it would be

a very small amount,” said Greg Stringham, vice-president at

industry group CAPP. “But I think they’re looking at it and saying,

if it meets my operating costs, I’m going to continue to produce. I

may not be getting the capital return – in fact they are not

60

getting the capital return they expected at these prices – but it

hasn’t caused anyone to go into shut-in mode yet.” In just a few

years, the amount of crude moving by rail has grown from almost

nothing to become railways’ fastest-growing business sectors,

accounting for as much as 10 per cent of railway revenues and 5 per

cent of Canadian oil exports by volume. The business soared as the

oil industry faced lengthy delays in approvals for major new

pipelines. It gained steam even after the deadly Lac Mégantic,

Que., oil-by-rail disaster in 2013, an incident that prompted

regulators to tighten rules about inspection and safety throughout

the continent. Oil producers and traders make money on the higher

prices oil fetches in other markets. They buy Western Canadian

Select – a benchmark heavy crude blend – in Alberta and pay to have

it carried by train to a refinery or hub in the United States,

where oil prices are higher. But the collapse in oil prices has

been accompanied by a narrowing of the price spread.

On Friday, WCS oil sold for $13.15 a barrel less than WTI. In

the Gulf Coast, the crude competes with Latin American grades such

as Mexican Maya. Last week, Maya sold in the Gulf Coast for $9.95 a

barrel more than WCS in Alberta. Meanwhile, it costs $15 to $22 to

move a Canadian barrel to Texas by train. The same trip in a

pipeline costs less than $12 a barrel. Canadian Pacific Railway

Ltd. saw a dip in volumes in the final three months of 2014, and

has slashed its expected volumes for 2015 to 140,000 carloads from

200,000, blaming the collapse in crude prices. CP and its Montreal-

based rival Canadian National Railway Co. expect strong growth in

the segment as new oil terminals are built, and as approval

processes drag on for such major pipelines as TransCanada Corp.’s

Keystone XL and Enbridge Inc.’s Northern Gateway. Shipping crude by

rail has ballooned in popularity because the railroads reach places

61

pipelines do not. Using heated tank cars, heavy oil or bitumen

requires less – or no – diluting fluid than if it were to flow by

pipeline, a cost saving for shippers.

John Zahary, chief executive of oil-by-rail company Altex

Energy Ltd., said he expects volumes this year to be stable despite

the shrinking commodity price spreads. Altex, an early entrant into

the resurgent transport option, runs several loading terminals in

Alberta and Saskatchewan. Much of that is due to the contractual

nature of the business, where companies must deliver volumes or pay

a fee. “If you’re a long-term player, like a refiner, you’ve got to

keep your refinery full, or a producer, you’ve got to keep selling

your oil,” Mr. Zahary said. FirstEnergy Capital Corp. analyst

Steven Paget said it is hard to say which shippers are making money

moving by rail, “but we know it’s tight.” He said the plunge in oil

prices has shippers and producers looking more carefully at the

costs of moving oil to markets. But with several new terminals

expected to open this year, overall volumes should rise. Executives

with Valero Energy Corp., a major refiner with plants in Texas,

Quebec and elsewhere, said last week that the company was just

breaking even on Canadian crude-by-rail volumes delivered to the

Gulf Coast versus waterborne Latin American alternatives. MEG

Energy Corp. is still moving oil by train from the Canexus terminal

in Edmonton to reach higher-priced markets and overcome pipeline

constraints. The oil producer – which has announced deep budget

cuts for 2015 – shares a pipeline with Devon Energy Corp. that runs

from Fort McMurray to Edmonton, which offers access as well as

terminals that connect with both major railways. “We’re absolutely

moving by rail. For us it’s all about flexibility. You look at the

cost of transportation versus the price that you can receive at

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high-priced markets and you just work that equation,” Mr. Bellows

said.

Imperial Oil, meanwhile, said the drop in oil prices has not

changed its plans to open a rail terminal in partnership with

Kinder Morgan in Edmonton. “Our long-term growth strategy is not

significantly affected by near-term crude prices. And the plans

have to be tested to accommodate price swings,” said Imperial’s

Leanne Dohy. “It’s important to keep in mind that these are

decades-long investment decisions. You take them with the view that

they have to be able to perform across a broad range of pricing.”

4.3 SHIPPING GAINS ON LOW OIL PRICES AND VOLATILITY

Investors perceive crude and products as the two shipping

sectors to benefit most after the sharp fall in oil prices, while

they expect LNG to be heading for a recovery in 2016, according to

the results of electronic audience polls at the DNB Markets annual

Oil, Offshore & Shipping conference in Oslo. However, despite

investors’ general impressions, senior shipping management at the

event’s panel discussions see low oil prices as beneficial across

the board in their industry. Low oil prices meant that the general

sentiment was unmistakeably positive and, in cases, downright

bullish among some of the shipping industry’s senior bosses. DNB’s

well-attended event was split between offshore services on the

first day and commercial shipping on the second, which tended to be

mirror images of one another in terms of market sentiment among the

session panellists. For visual representation of this mirror, DNB’s

broad segment plotting of “where we are in the cycle” (see graphic

below) gives a loose, top-down view of the current contrasting

states of shipping and offshore. As one of the many electronic

audience polls showed a majority opinion for oil prices to average

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between $70 and $79 per barrel for Brent in 2016, Navios Maritime

Acquisition vice-chairman Ted Petrone, who holds various roles

within the Navios group, referred to that level as positive for

worldwide growth in gross domestic product (GDP).

“I think a low oil price is positive across the board for all

the shipping sectors,” said Petrone. “If that last poll was correct

and we are going to be sitting at $70 per barrel, I would say the

calculation is probably a $1.5-trillion-positive impact on oil-

consuming economies. It takes a while for that to come into the

system but I think you’ll start seeing better GDP numbers going

forward, which is good for consumption going forward.” However,

while low oil prices are positive for consumer demand, the constant

change in the oil price is even better, says Petrone. “For those

who play the game, we want volatility,” he said. “What’s really

good about the products side today is that the price of crude is

jumping around. When the price of crude is not steady, you’ve got

differentials between geographic regions, which is when the traders

come in and they start moving. That’s why you are seeing a lot of

[medium range] MR movements, inter-ocean and inter-Pacific trading

between refineries and such.” “Since we look at everything in

Navios, I sort of compare it to congestion on the dry side. It is

very difficult to factor in but you get a lot of trading between

European states and out in the Far East, and I think it is very

good for products and a flat oil price is not.” Euronav chief

executive Paddy Rodgers echoed this take on volatility, as well as

the big benefit for GDP from low oil prices, while placing the

positive impact on all shipping sectors. “Volatility is always

good. When the market is flat, generally somebody else has control

of it and, when they are not in control, we, as shippers, get more

opportunities. I think it is generally good across the board,” said

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Rodgers. “We had five years when it rained stones on shipowners.

Too many ships, demand destruction, withdrawal of debt as a result

of the financial crisis — all of these things were going on at the

same time.” While blaming prices above $100 per barrel for the

resulting ramp-up of too much production, Rodgers views “cheap oil”

as a particularly important bonus.

“The great news for us in shipping is that we are going to get

demand stimulation,” he said. “We are going to get drag-through

demand because all of a sudden, oil is valuable energy again. It is

going to be workable and there is going to be more crude shipped

and more products shipped.” Although they are reduced estimates, if

International Energy Agency (IEA) projections play out for world

demand growth at 1.2 million barrels per day in 2016, 2017 and

2018, this will spark a requirement to add 40 to 50 VLCCs each

year, if the oil all gets shipped long haul, he says.

 ‘Flat fleet growth’

“Most of the surface oil is in the Atlantic and most of the

demand is in the Asia-Pacific region. If we get a demand for 40 to

50 VLCCs, then happy days, because we’ve got virtually flat fleet

growth,” said Rodgers. On the LPG side, Aurora LPG chief executive

Borge Johansen points out how low oil prices affect LPG pricing and

vessel rates. “The propane price in Asia is normally priced off the

crude oil price because it is competing against naphtha into the

[petroleum-chemical] crackers, so if you want to increase demand

slightly, you put a small discount to naphtha and you can sell

almost as much propane as you want,” said Johansen. “In heating

seasons, it tends to be slightly higher than naphtha because

consumer demand picks up. For the shipping markets, I think it will

definitely affect the ability to take out higher rates in the spot

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market over time. Right now, we are earning very good money and if

the oil price is $50, I think rates now are around $100,000 per

day. It would most likely have been $200,000 per day if the oil

price were over $100. “We are very short on ships today. Over the

last month, I think between five and 10 cargoes have been cancelled

because there are not enough ships in the market.” On the natural

gas side, Hoegh LNG chief executive Sveinung Stohle also sees

benefits due to lower prices spurring more purchases.

 Natural gas chain

“I think it is important for everyone to try to distinguish

between oil and natural gas. Natural gas sort of lives a life

besides what happens in the crude market. LNG is, of course, part

of that but LNG is part of the natural gas chain,” Stohle said.

“Natural gas is priced off oil in most markets in the world with a

certain discount. When we look at all that’s happened in the world,

crude prices have come down 50% and LNG prices have also come down

with a large percentage, although not as much as 50%. There is a

time lag. For us, what that means is that demand goes up. When the

commodity becomes cheaper, demand increases. For Hoegh LNG and

FSRUs [floating storage and regasification units], which are

basically a means to import gas into a new market, the reduction in

the LNG price has been very good. We see an increase in demand for

our services.”

4.4 SHIPPING INDUSTRY TO BENEFIT AS OIL PRICES SINK

Operation costs of ships have gone down and demand for oil

tankers have picked up as some countries like China try to

stockpile oil taking advantage of the lower oil prices. “This is

having a positive effect on the shipping industry. We expect

profits of companies to go up,” said Per Wistoft, chief executive 66

officer of Dubai-based United Arab Chemical Carriers that operates

a big fleet of tankers in the Middle East and the Indian

subcontinent. Oil prices have been sliding for the past few months.

From a peak of $115 in June, prices have dropped to around $50 this

week. Analysts have predicted the trend to continue till the second

quarter of this year. According to Wistoft, bunkering costs have

almost halved since last year and the demand for oil tanker has

gone up. Bunkering costs of very large crude carries also known as

super tankers have come down from $40,000 per day to $20,000 per

day. “This has been a substantial help for shipping companies to

overcome the cost. Bunkering is one of the major expenses of the

shipping companies.” He predicted floating storage to increase due

to low oil prices. Floating storage is a method by which oil

companies hire large vessels to store oil and sell when the price

increases.The capital utilisation to procure oil is much less than

before due to falling oil prices, Bounty Marine Services that is

involved in bunkering of oil said.

Buying of diesel has become cheaper due to the market situation.

Entire shipping industry is going to benefit,” said Sudai Jallad,

the owner of Bounty Marine Services. He said they used to spend

$80,000 for buying 100 tonnes of diesel earlier. “We now get the

same quantity for $50,000. It is 40 per cent less.” Meanwhile, an

analyst said China is in an oil buying spree due to lower oil

prices but it is unlikely to prop up global oil markets. “In this

time of low oil prices, it comes as no surprise that China is

stockpiling fuel,” said Daniel Ang, investment analyst from Phillip

Futures. He added that China is one of the biggest consumers and

importers of crude oil, and taking advantage of oil when prices are

low is a strategic move. “However, we see the big uptake of crude

oil by China to not be reflective of China’s crude oil demand.

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These stockpiles would likely remain unused in the short term and

thus, giving only an artificial boost on crude demand,” Ang said.

According to shipping consultancy Drewry, container shipping

profitability is expected to improve in 2015, despite record vessel

deliveries, driven by lower unit costs, It said more carriers are

expected to be profitable in 2015, provided that a number of

tailwinds prevail. These include continuing carrier focus on vessel

deployment; fuel costs remaining low; recovering demand; successful

outcome of annual BCO (Beneficial Cargo Owner) contract

negotiations; and new operational alliances delivering greater

market stability.

4.5 TEN REASONS WHY A SEVERE DROP IN OIL PRICES IS A PROBLEM

Not long ago, I wrote Ten Reasons Why High Oil Prices are a

Problem. If high oil prices can be a problem, how can low oil

prices also be a problem? In particular, how can the steep drop in

oil prices we have recently been experiencing also be a problem?

Let me explain some of the issues:

Issue 1. If the price of oil is too low, it will simply be left in

the ground.

The world badly needs oil for many purposes: to power its

cars, to plant it fields, to operate its oil-powered irrigation

pumps, and to act as a raw material for making many kinds of

products, including medicines and fabrics. If the price of oil is

too low, it will be left in the ground. With low oil

prices, production may drop off rapidly. High price encourages more

production and more substitutes; low price leads to a whole series

of secondary effects (debt defaults resulting from deflation, job

loss, collapse of oil exporters, loss of letters of credit needed

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for exports, bank failures) that indirectly lead to a much quicker

decline in oil production.

The view is sometimes expressed that once 50% of oil is

extracted, the amount of oil we can extract will gradually begin to

decline, for geological reasons. This view is only true if high

prices prevail, as we hit limits. If our problem is low oil prices

because of debt problems or other issues, then the decline is

likely to be far more rapid. With low oil prices, even what we

consider to be proved oil reserves today may be left in the ground.

Issue 2. The drop in oil prices is already having an impact on

shale extraction and offshore drilling.

While many claims have been made that US shale drilling can be

profitable at low prices, actions speak louder than words. (The

problem may be a cash flow problem rather than profitability, but

either problem cuts off drilling.) Reuters indicates that new oil

and gas well permits tumbled by 40% in November. Offshore drilling

is also being affected. Transocean, the owner of the biggest fleet

of deep water drilling rigs, recently took a $2.76 billion charge,

among a “drilling rig glut.”

Issue 3. Shale operations have a huge impact on US employment. 

Zero Hedge posted the following chart of employment growth, in

states with and without current drilling from shale formations:

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Figure 1. Jobs in States with and without Shale Formations, from Zero Hedge.

Clearly, the shale states are doing much better, job-wise.

According to the article, since December 2007, shale states have

added 1.36 million jobs, while non-shale states have lost 424,000

jobs. The growth in jobs includes all types of employment,

including jobs only indirectly related to oil and gas production,

such as jobs involved with the construction of a new supermarket to

serve the growing population. It might be noted that even the “Non-

Shale” states have benefited to some extent from shale drilling.

Some support jobs related to shale extraction, such as extraction

of sand used in fracking, college courses to educate new engineers,

and manufacturing of parts for drilling equipment, are in states

other than those with shale formations. Also, all states benefit

from the lower oil imports required.

Issue 4. Low oil prices tend to cause debt defaults that have wide

ranging consequences. If defaults become widespread, they could

affect bank deposits and international trade.

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With low oil prices, it becomes much more difficult for shale

drillers to pay back the loans they have taken out. Cash flow is

much lower, and interest rates on new loans are likely much higher.

The huge amount of debt that shale drillers have taken on suddenly

becomes at-risk. Energy debt currently accounts for 16% of the US

junk bond market, so the amount at risk is substantial. Dropping

oil prices affect international debt as well. The value of

Venezuelan bonds recently fell to 51 cents on the dollar, because

of the high default risk with low oil prices.  Russia’s Rosneft is

also reported to be having difficulty with its loans.

There are many ways banks might be adversely affected by

defaults, including

Directly by defaults on loans held by a bank

Indirectly, by defaults on securities the bank owns that

relate to loans elsewhere

By derivative defaults made more likely by sharp changes in

interest rates or in currency levels

By liquidity problems, relating to the need to quickly sell or

buy securities related to ETFs

After the many bank bailouts in 2008, there has been

discussion of changing the system so that there is no longer a need

to bail out “too big to fail” banks. One proposal that has been

discussed is to force bank depositors and pension funds to cover

part of the losses, using Cyprus-style bail-ins. According to some

reports, such an approach has been approved by the G20 at a meeting

the weekend of November 16, 2014. If this is true, our bank

accounts and pension plans could already be at risk. Another bank-

related issue if debt defaults become widespread, is the

possibility that junk bonds and Letters of Credit2 will become

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outrageously expensive for companies that have poor credit ratings.

Supply chains often include some businesses with poor credit

ratings. Thus, even businesses with good credit ratings may find

their supply chains broken by companies that can no longer afford

high-priced credit. This was one of the issues in the 2008 credit

crisis.

Issue 5. Low oil prices can lead to collapses of oil exporters, and

loss of virtually all of the oil they export.

The collapse of the Former Soviet Union in 1991 seems to be

related to a drop in oil prices.

Oil production and price of the Former Soviet Union, based on BP Statistical Review of

World Energy 2013.

Oil prices dropped dramatically in the 1980s after the issues

that gave rise to the earlier spike were mitigated. The Soviet

Union was dependent on oil for its export revenue. With low oil

prices, its ability to invest in new production was impaired, and

its export revenue dried up. The Soviet Union collapsed for a

number of reasons, some of them financial, in late 1991, after

several years of low oil prices had had a chance to affect its

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economy. Many oil-exporting countries are at risk of collapse if

oil prices stay very low very long. Venezuela is a clear risk, with

its big debt problem. Nigeria’s economy is reported to be

“tanking.” Russia even has a possibility of collapse, although

probably not in the near future.

Even apart from collapse, there is the possibility of

increased unrest in the Middle East, as oil-exporting nations find

it necessary to cut back on their food and oil subsidies. There is

also more possibility of warfare among groups, including new groups

such as ISIL. When everyone is prosperous, there is little reason

to fight, but when oil-related funds dry up, fighting among

neighbors increases, as does unrest among those with lower

subsidies.

Issue 6. The benefits to consumers of a drop in oil prices are

likely to be much smaller than the adverse impact on consumers of

an oil price rise. 

When oil prices rose, businesses were quick to add fuel

surcharges. They are less quick to offer fuel rebates when oil

prices go down. They will try to keep the benefit of the oil price

drop for themselves for as long as possible.

Airlines seem to be more interested in adding flights than

reducing ticket prices in response to lower oil prices, perhaps

because additional planes are already available. Their intent is to

increase profits, through an increase in ticket sales, not to give

consumers the benefit of lower prices. In some cases, governments

will take advantage of the lower oil prices to increase their

revenue. China recently raised its oil products consumption tax, so

that the government gets part of the benefit of lower prices.

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Malaysia is using the low oil prices as a time to reduce oil

subsidies.

Most businesses recognize that the oil price drop is at most a

temporary situation, since the cost of extraction continues to rise

(because we are getting oil from more difficult-to-extract

locations). Because the price drop this is only temporary, few

business people are saying to themselves, “Wow, oil is cheap again!

I am going to invest a huge amount of money in a new road building

company [or other business that depends on cheap oil].” Instead,

they are cautious, making changes that require little capital

investment and that can easily be reversed. While there may be some

jobs added, those added will tend to be ones that can easily be

dropped if oil prices rise again.

Issue 7. Hoped for crude and LNG sales abroad are likely to

disappear, with low oil prices.

There has been a great deal of publicity about the desire of

US oil and gas producers to sell both crude oil and LNG abroad, so

as to be able to take advantage of higher oil and gas prices

outside the US. With a big drop in oil prices, these hopes are

likely to be dashed. Already, we are seeing the story, Asia stops

buying US crude oil. According to this story, “There’s so much

oversupply that Middle East crudes are now trading at discounts and

it is not economical to bring over crudes from the US anymore.” 

LNG prices tend to drop if oil prices drop. (Some LNG prices

are linked to oil prices, but even those that are not directly

linked are likely to be affected by the lower demand for energy

products.) At these lower prices, the financial incentive to export

LNG becomes much less. Even fluctuating LNG prices become a problem

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for those considering investment in infrastructure such as ships to

transport LNG.

Issue 8. Hoped-for increases in renewables will become more

difficult, if oil prices are low.

Many people believe that renewables can eventually take over

the role of fossil fuels. (I am not of view that this is possible.)

For those with this view, low oil prices are a problem, because

they discourage the hoped-for transition to renewables. Despite all

of the statements made about renewables, they don’t really

substitute for oil. Biofuels come closest, but they are simply oil-

extenders. We add ethanol made from corn to gasoline to extend its

quantity. But it still takes oil to operate the farm equipment to

grow the corn, and oil to transport the corn to the ethanol plant.

If oil isn’t around, the biofuel production system comes to a

screeching halt.

Issue 9. A major drop in oil prices tends to lead to deflation, and

because of this, difficulty in repaying debts.

If oil prices rise, so do food prices, and the price of making

most goods. Thus rising oil prices contribute to inflation. The

reverse of this is true as well. Falling oil prices tend to lead to

a lower price for growing food and a lower price for making most

goods. The net result can be deflation. Not all countries are

affected equally; some experience this result to a greater extent

than others.

Those countries experiencing deflation are likely to

eventually have problems with debt defaults, because it will become

more difficult for workers to repay loans, if wages are drifting

downward. These same countries are likely to experience an outflow

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of investment funds because investors realize that funds invested

these countries will not earn an adequate return. This outflow of

funds will tend to push their currencies down, relative to other

currencies. This is at least part of what has been happening in

recent months.

The value of the dollar has been rising rapidly, relative to

many other currencies. Debt repayment is likely to especially be a

problem for those countries where substantial debt is denominated

in US dollars, but whose local currency has recently fallen in

value relative to the US dollar.

US Dollar Index from Intercontinental Exchange

The big increase in the US dollar index came since June 2014

(Figure 3), which coincides with the drop in oil prices. Those

countries with low currency prices, including Japan, Europe,

Brazil, Argentina, and South Africa, find it expensive to import

goods of all kinds, including those made with oil products. This is

part of what reduces demand for oil products. China’s yuan is

relatively closely tied to the dollar. The collapse of other

currencies relative to the US dollar makes Chinese exports more

expensive, and is part of the reason why the Chinese economy has

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been doing less well recently. There are no doubt other reasons why

China’s growth is lower recently, and thus its growth in debt.

China is now trying to lower the level of its currency.

Issue 10. The drop in oil prices seems to reflect a basic

underlying problem: the world is reaching the limits of its debt

expansion.

There is a natural limit to the amount of debt that a

government, or business, or individual can borrow. At some point,

interest payments become so high, that it becomes difficult to

cover other needed expenses. The obvious way around this problem is

to lower interest rates to practically zero, through Quantitative

Easing (QE) and other techniques. (Increasing debt is a big part of

pumps up “demand” for oil, and because of this, oil prices. If this

is confusing, think of buying a car. It is much easier to buy a car

with a loan than without one. So adding debt allows goods to be

more affordable. Reducing debt levels has the opposite effect.) QE

doesn’t work as a long-term technique, because it tends to create

bubbles in asset prices, such as stock market prices and prices of

farmland. It also tends to encourage investment in enterprises that

have questionable chance of success. Arguably, investment in shale

oil and gas operations are in this category.

As it turns out, it looks very much as if the presence or

absence of QE may have an impact on oil prices as well, providing

the “uplift” needed to keep oil prices high enough to cover

production costs.

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World “liquids production” (that is oil and oil substitutes) based on EIA data, plus OPEC

estimates and judgment of author for August to October 2014. Oil price is monthly average

Brent oil spot price, based on EIA data.

The sharp drop in price in 2008 was credit-related, and was

only solved when the US initiated its program of QE started in late

November 2008. Oil prices began to rise in December 2008. The US

has had three periods of QE, with the last of these, QE3, finally

tapering down and ending in October 2014. Since QE seems to have

been part of the solution that stopped the drop in oil prices in

2008, we should not be surprised if discontinuing QE is

contributing to the drop in oil prices now.

Part of the problem seems to be differential effect that

happens when other countries are continuing to use QE, but the US

not. The US dollar tends to rise, relative to other currencies. QE

allows more borrowing from the future than would be possible if

market interest rates really had to be paid. This allows financiers

to temporarily disguise a growing problem of un-affordability of

oil and other commodities. The problem we have is that, because we

live in a finite world, we reach a point where it becomes more

expensive to produce commodities of many kinds: oil (deeper wells,

fracking), coal (farther from markets, so more transport costs),

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metals (poorer ore quality), fresh water (desalination needed), and

food (more irrigation needed). Wages don’t rise correspondingly,

because more and more labor is needed to provide less and less

actual benefit, in terms of the commodities produced and goods made

from those commodities. Thus, workers find themselves becoming

poorer and poorer, in terms of what they can afford to purchase.

QE allows financiers to disguise growing mismatch between what

it costs to produce commodities, and what customers can really

afford. Thus, QE allows commodity prices to rise to levels that are

unaffordable by customers, unless customers’ lack of income is

disguised by a continued growth in debt. Once commodity prices

(including oil prices) fall to levels that are affordable based on

the incomes of customers, they fall to levels that cut out a large

share of production of these commodities. As commodity production

drops to levels that can be produced at affordable prices, so does

the world’s ability to make goods and services. Unfortunately, the

goods whose production is likely to be cut back if commodity

production is cut back are those of every kind, including houses,

cars, food, and electrical transmission equipment.

4.6 THE IMPACT OF REDUCED OIL PRICES ON THE TRANSPORTATION

SECTOR

The precipitous drop in oil prices is among the most

significant—and unexpected—forces in the global economy today.

Thanks to a combination of increased production (especially in the

U.S.) and muted demand, the spot price of West Texas Intermediate

crude fell from US$109 in July 2014 to $45 in January 2015, and has

since rebounded to above $50. The winners are obvious: consumers,

owners of gas-guzzling vehicles, energy-intensive industries. So,

too, are the apparent losers: oil exploration and services firms,

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countries that are dependent on fossil fuels, manufacturers of

hybrid cars.

The vital transportation sector has been a beneficiary of

lower oil prices. Not only will it experience direct savings

derived from lower fuel prices, but the expected uptick in consumer

spending will positively impact global trade, and, consequently,

transportation. But the benefits aren’t being shared equally by all

modes of transportation. In each sector, low prices have opened up

a host of strategic questions for companies to consider. And

because it is unclear whether the low prices will last,

transportation companies are understandably reacting with caution.

4.6.1 AIRLINES

Airlines stand to gain the most from reduced prices, given

that roughly a third of their costs are associated with fuel. Even

better, thus far airlines have yet to face direct competitive

pressures to pass fuel savings on to customers. Any ticket price

reductions will be driven primarily by competitive dynamics (old-

fashioned supply and demand), rather than by reductions in fixed

fuel surcharge rates. As a result, airline profitability has

soared; the International Air Transport Association projected last

fall that global airlines would reap a collective profit of $19.9

billion in 2014, and $25.0 billion in 2015.

But the perception of an unmitigated windfall may be

exaggerated. In recent years, as Reuters has reported, some

airlines sought to protect themselves from volatile, often high

energy prices by locking up longer-term hedging contracts at a

price of $100 per barrel or more. As the price of oil plummeted,

these hedges resulted in large losses. For example, according to

Reuters, Delta, which should stand to gain at least $1.7 billion in80

2015 thanks to lower fuel prices, will actually lose an estimated

$1.2 billion to fuel hedges in the same time period, and Southwest

Airlines’ hedges may result in the airline saving only $0.80 for

every $1.00 drop in oil prices. Nonetheless, given the drop in oil

prices, airlines have the opportunity to rewrite their hedging

contracts in order to lock in prices around $50 per barrel for the

foreseeable future.

Although the lower energy costs may not lead directly to

sharply lower airline tickets, they may bring about a better

customer experience for the long-suffering flying public. First,

since the break-even capacity required for a profitable flight will

fall, airlines can introduce new routes and expand capacity on

existing routes to capture incremental demand—all while accepting

lower load factors. (Translation: It’s slightly less likely that

you’ll end up in a middle seat.) This would in turn allow airlines

to further maximize aircraft utilization or even acquire additional

planes. In another piece of good news for customers, if demand

flatlines or falls as capacity expands, airlines may engage in

price wars in order to fill these additional seats. A quick rise in

oil prices, however, could make reduced load factors again

unprofitable. Airlines should be cautious about undertaking longer-

term capacity expansion in order to avoid overexposing themselves

to future volatility in fuel costs and demand.

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SECTION FIVE

5.0 SUMMARY AND CONCLUSION, RECOMMENDATION

5.1 CONCLUSION AND SUMMARY

Following four years of stability at around $105/bbl, oil

prices fell sharply in the second half of 2014. Compared to the

early 2011 commodity price peaks, the decline in oil prices was

much larger than that in non-oil commodity price indices. The

decline in oil prices was quite significant compared with the

previous episodes of oil price drops during the past three decades.

5.2 RECOMMENDATION

There have been a number of long- and short-term drivers

behind the recent plunge in oil prices: several years of large

upward surprises in oil supply; some downward surprises in demand;

unwinding of some geopolitical risks that had threatened

production; change in OPEC policy objectives; and appreciation of

U.S. dollar. Supply related factors have clearly played a dominant

role, with the new OPEC strategy aimed at market share triggering a

further sharp decline since November.

The decline in oil prices has significant macroeconomic,

financial and policy implications. If sustained, it will support

activity and reduce inflationary, external, and fiscal pressures in

oil-importing countries. On the other hand, it would affect oil-

exporting countries adversely by weakening fiscal and external

positions and reducing economic activity. Low oil prices affect

investor sentiment about oil-exporting emerging market economies,

and can lead to substantial volatility in financial markets, as

already occurred in some countries in the last quarter of 2014.

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However, declining oil prices also present a significant window of

opportunity to reform energy taxes and fuel subsidies, which are

substantial in several developing countries, and reinvigorate

reforms to diversify oil-reliant economies.

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REFERENCES

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