Column  International Exchange  2015.06.15

Effects of the collapse of shale oil bubble on the United States' financial sector and on employment

1.Falling oil prices

Oil prices (WTI) have dropped from USD 105.24 in June 2014 to USD 52.00 of late. There is a consensus that this is due to excess supply in the market. A large growth in demand for oil is not expected from emerging countries including China which has faced a slowdown of economic growth recently. The supply of oil is increasing substantially due mainly to the enhanced production of shale oil in the United States. Despite this, Middle East oil producing countries have decided not to reduce production. At the meeting of OPEC on November 27, Saudi Arabia strongly opposed cutting production and oil prices continued to fall.

2.Saudi Arabia's anger

In Chapter Three I will explain Saudi Arabia's aims in letting oil prices decline. Before that, let me explain Saudi Arabia's deep dissatisfaction with the policies of the United States since 9/11 which has motivated this policy.

(1)Right after 9/11, the United States and its allies launched bombing raids on Afghanistan in October 2001 and within two months took control of the country. Following this, the US and UK governments turned to Iraq and Saddam Hussein in March 2003, putting all Iraq under their control in about two months.

(2)This worked for the benefit of Iran. For instance, Afghanistan which was governed by the Taliban and Al-Qaida created problems for Iran as radical Islamic ideology in Afghanistan could have a contagious effect on Iran. Thanks to the peace brought to Afghanistan by the United States-led coalition, these problems were removed.

(3)Iraq, a country with a Shia majority, was governed by a Sunni leader Saddam Hussein. This was a consequence of British colonial policy which always promoted minority leaders to govern majorities. Iraq, ruled by Saddam Hussein, had been an enemy of Iran, with repeated regional conflicts since the late 1980s. The overthrow of Hussein resulted in a new country dominated by Shia, which became friendly to Iran.

(4)Accordingly Saudi Arabia, who believes itself the leader of the Sunni faith, and therefore the leading antagonist of Shia Iran, has been irritated by the actions of the United States.

3.The aims of Saudi Arabia
(1)Pressure on Iran

The Rouhani regime of Iran, established in June 2013, has sought rapprochement with the West. Its return to the international community, both economically and politically, is getting closer after the 40 years of isolation since the late 1970s. As Iran is the country with the largest Shiite population, Saudi Arabia, as the leader of Sunni, cannot afford to ignore this development. Saudi Arabia's intent in letting the prices of petroleum products decline could be interpreted as an attempt to weaken the financial strength of Iran, whose major exports are such products.

(2)Pressure on Russia

Falling oil prices would have a damaging effect on the finances of the major supporter of Iran, Russia, because 60 % of its revenues come from taxes on the export of oil. In this manner Saudi Arabia aims to put pressure on Russia. After the fall in oil prices following the OPEC meeting at the end of November the Russian Ruble started to decline and, on December 16th, hit the lowest level where one US dollar equaled 80 rubles. The major cause of the depreciation was a panic among Russian companies regarding their ability to refinance US dollar denominated debts. It is also true, however, that falling oil prices was the major factor. Subsequently, thanks to various actions taken by the Central Bank of Russia, the Russian ruble has stabilized at a level of fifty rubles to one US dollar.

In fiscal 2014, the Russian government assumed an oil price of 90 dollars per barrel. However oil prices were substantially above 100 dollars per barrel until mid-2014 and actual revenue was higher than the initial estimate. Accordingly it is believed that the government has had no problems in its 2014 budget. However, if oil prices stay low in 2015, the Russian government will have to conduct a major review of its expenditures.

(3)The effect on shale oil

The aforementioned motivations of Saudi Arabia have been widely reported in the media. An additional objective is to weaken shale oil production in the United States and return the US to the status of being an oil-importing country, particularly dependent on oil from Saudi Arabia. Recently, thanks to shale oil, the United States had changed to being an oil exporter rather than an oil importer. The average break-even point of shale oil is 75 dollars per barrel, which is much higher than the current oil price. Under present circumstances, only extraordinarily efficient drill wells can make a profit.

4.The effects of falling oil prices on the US economy

(1)Under this backdrop, starting in November 2014, oil companies started to dismiss employees involved in the production of shale oil. One projection stated that 400,000 jobs will be lost in 2015.

(2)A deep concern has arisen, that falling oil prices would have a serious, adverse impact on major investment banks in the United States which have purchased a sizable amount of derivatives related to shale oil in the futures market. Since the benchmark prices of such derivatives is set at 85 dollars per barrel, if oil prices stay at the current level, major investment banks will be reporting tremendous losses towards the end of this year or the spring of 2016, when these derivatives mature. This may lead those banks to fail. One investment bank has exposure to such derivatives to the value of 100 billion dollars. To address this issue, the United States Congress revised the Dodd-Frank Act in December 2014 in the House of Representatives and in January 2015 in the Senate. The safety net under the previous act did not cover derivatives related to commodities including oil and grains, which the new act does. Therefore should an investment fail, a legal framework to bail out the investor already exists. However a different challenge may be the growing criticism in the United States towards financial institutions. Whether a bailout would be politically feasible is unclear as this would be a second bail-out, after that carried out during the Lehman shock. Even if the bail-out were accepted it might result in the reintroduction of the separation of investment banks and commercial banks.

(3)The IMF's GFSR (Global Financial Stability Report), which was made public at the time of the IMF spring meetings, rang alarm bells regarding the increased risk caused by expanded investments in unregulated areas such as shadow banks and investment trusts. In this regard, it is pointed out that the outstanding loans to the oil industry have grown to a level 2.7 times that at the Lehman shock.

Since 2013 the United States Federal Reserve Board had recommended that sizable leveraged loans directed principally to the energy sector, including shale oil, wind power and solar power should be stopped. The oil industry borrowed heavily in the last ten years and bought back shares as well as paying out dividends during this period. With a lack of attractive investments in other areas the shale oil boom attracted heavy investment to the oil industry. It is very important to monitor the outstanding debts in this industry over the coming months and years.