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Oil has been touted as the culprit that has caused countries all over the world to experience slower economic growth and also why inflation simply cannot rise, but WHY?  Is oil truly the culprit?  I say, NO!

Remember post millennium, the period from 2002 to 2006 when the whole world was booming, what was the price of oil? You guessed it right, it was at an average of $40/- per barrel.  What happened next was that Wall Street through the derivative boys started to speculate on Black Gold, driving the prices higher up to the peak in July 2008 at $145/- just before the crash of Wall Street.  This created an opportunity for new producers to come online, including alternate oil sands and shale oil.  Though their cost of production was in the range of $45 to $70 per barrel, it was still profitable because Black Gold was up there in the $100/- per barrel price range.

Capital started moving into the oil and gas industry and the supporting industries including logistics, marine, steel, etc.  Cities in Alberta, Canada which was previously a sleepy city became the darling in Canada, people moved, property prices rose. The same thing happened in Texas and Florida, United States and also in Brazil.

Fundamentally, what also changed in the oil and gas industry is the way exploration was financed.  Traditionally, new exploration was usually financed with equity.  However, with the escalating oil prices, banks, capital markets and debt markets became more aggressive in financing new exploration with debt financing and lending based on future cash flow.  The amount of capital that went into the oil and gas industry from 2007 to 2014 was in excess of $1 Trillion.  The global market capitalization of O&G companies was above $6Trillion in June 2014 when oil was at $110/- per barrel.  Today, the market capitalization has fallen by more than  half to $2.48Trillion at today’s oil prices of $31/- per barrel.

More importantly, in the past 5 years of the total capital raised from the capital markets and debt markets to fund and fuel businesses, more than 50% of these capital went to the O&G sector.  In other words, we saw huge swings towards one sector and the concentration risk of capital and resources into the O&G sector.  This is not healthy for any economy to be highly depended on one sector.

To make matters worse, more and more businesses decided to get involved in the supply chain of Black Gold from EPC, to stainless steel factories, to marine engineering firms, to shipping lines, all wanting a piece of this lucrative pie.

Much like what happened in Australia during the mining boom, Perth became the sweetheart city in Australia with people flocking to live there because it was closer to the mines.  Capital and lending mostly went  to the mining sector.  Salaries were also double that of lawyers and general doctors.  When China slowed down what happened to western Australia and the mining industry?  Collapsed!  Today, Australia is going through a painful process of rebalancing its economy to go back to a more broad based economy.

So, it was no surprise when oil prices started to fall in 2015, especially, when it hit below $40/- that pain would be felt throughout the supply chain.  Did the price of oil fall because of poor economic growth globally? No!

Oil prices fell because the Middle Eastern, the largest Black Gold producers in the world was fed up with other countries taking away their rice bowl.  So, the Middle Eastern started flooding the market by increasing the supply in the marketplace.  This had the effect of driving the price of oil down significantly to its current levels.

Basically, the Middle Easterns wants to ‘kill’ the new oil producers, reduce the number of players in the global arena before they curtail supply and let prices rise again.  At the current price of crude oil, quite a significant number of producers will have to close down because of the negative carry and higher debt cost.  A number of them in the U.S., and Latin America have already collapsed.  Of course, that means everyone connected to the O&G sector is also going to get hurt including the supporting industries.  However, this is to be expected because the respective economies around the world which was previously, biased in O&G, now need to rebalance its economy to a more broad base one.

This is going to take time and the Middle Easterns are in no hurry as their cost of production is in the $6 to $8 per barrel range, so they are still making billions of dollars with oil prices at $38 per barrel.

 

 

 

 

 

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