Note: This article was published in Industrious Oil & Gas Magzine, issue 2, 2016
http://www.digionline.co.uk/indusoag/2016/issue2/#p=25
Not very long ago oil prices were traded at well below $20/BBL and OPEC anxiously come up with a mechanism which it named the 'OPEC Price Band' for between $22-$28/BBL. The principle for this price band, was that OPEC members find that this price range as the reasonable minimum which is still sufficient for the growth of oil and gas industry and to meet the government cash requirements. However, only few years after this mechanism was introduced, oil prices got out of hand and OPEC was forced to abolish its price band in favour of higher market price. No doubt, oil producers always look for higher oil prices as it improves profitability, more funds for further development of oil and gas resources and to meet the growing cash requirements of governments.
Oil prices rose higher and higher and in July of 2008 peaked at $147/BBL - bravo for oil produces and oil exporters; however, terrible for the oil importing countries. There are many reasons for the elevation in oil prices from 2003 - market fundamentals, civil unrest/strikes in some of the major oil producing countries, flip/flop of inventories, speculators, hurricanes, conflict in Middle East, and higher cost of production etc. The world has also witnessed oil prices of over $100 during 2008, collapsing to below $40 late 2008 and early 2009. Again the world has witnessed era of sustained higher prices of over $100/BBL for quite extended period of time before plunging to below $30/BBL. The question is why were oil producers at one stage were quite satisfied with a self-imposed price band of $22-28/BBL and at another time not happy with a price of $50/BBL?
As the oil prices increase the revenue requirements of oil exporting countries also increases. In the regime of higher oil prices, cost of upstream and downstream also increases as happened during 2007/2008 - when daily drilling rates more than doubled and also the cost of steel and other materials skyrocket. The other obvious reason is that the governments are committed to improve the wellbeing of their people and therefore government expenditure increases for the development of infrastructure - roads, rail, ports, schools, hospitals etc, to further enhance/improve the quality of life for the masses. This perception that oil revenue is a cash-cow is held by all - suppliers to both governments and NOCs also inflate their prices to enjoy the profits of a high price-per-barrel environment. Due to this tendency, generally oil producing nations are stretched beyond their expected means and continue look for higher and higher oil and gas revenues. The easy pick is higher oil prices that could easily fulfil their budgetary requirements. Consequently, the fiscal breakeven oil prices also continue to move upward. In recent memory breakeven oil prices were over $100/BBL for some of oil producing countries; however, when oil prices slump down to below $45/BBL, most OPEC members see $70 a barrel as a fair price for oil. One may argue how come this flip flop of fair prices from above $100 to $70/BBL in a matter of months?
The oil and gas sector is the dominant source of governmental revenue in most of the oil exporting countries and therefore quite sensitive to the fluctuation of oil and gas prices. The governments generally form their expectations influenced by current or near term oil prices and assume that oil prices shall continue to move upward. In a regime of higher oil prices everything looks good and the tendency is to believe that high oil prices will continue. Based on their expectations of higher oil prices they prepare and approve public sector development projects hoping for higher oil based revenues. A government’s aggressive expansion plan is defeated when oil prices collapse. In a market of lowered oil prices the issue becomes one of how to finance the committed public sector projects - deficit financing, borrowings, issuance of bonds or using sovereign funds; essentially the basic principle of economics 'cut your coat according to size of your cloth'. Too optimistic a budget leads to deficit financing or drawdown from sovereign funds and putting unnecessary pressure on national oil companies (NOCs). To avoid such abrupt flip flop break-even prices a national government need to develop a compromising strategy, remove lavish energy subsidies, impose income taxes, downward adjusting break-even prices and adopt diversification policies away from the hydrocarbon sector; promoting non-hydrocarbon sectors to avoid further “catch 22” situations.
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