The Paradox of Falling Petrol Prices

Offshore oil rig. (Photo: Pete Markham)

Anyone that drives a car will have noticed that oil prices have been rapidly dropping over the last six months. Although this may come as a pleasant surprise when paying for your petrol at the pumps, the short-term effects to the British economy go far beyond the effective tax cut through lower heating bills and cheaper transport. The British oil industry has been caught in the crossfire of the oil war between America and Saudi Arabia, and unless George Osborne plays his cards right, it may struggle to heal its wounds.

 

On average, the price of a litre has fallen by 21 pence in the last six months. This can be partly credited to the demand for oil slowly tapering off, due to weak economic activity since the global recession, and an increase in renewables and other energy sources. However, the laws of supply and demand that economists cling to so tightly, fall short in explaining these trends; it is clear that politically motivated factors are also at play here.

 

The US has recently become the largest oil producer in the world, overtaking both Saudi Arabia and Russia to reach the top spot. The shale oil industry, which involves ‘fracking’ (blasting rocks with water and sand in order to extract the oil inside) is the new dark horse of the energy industry and this explains how the US now produces around 9 million barrels a day. The US is also the largest importer of oil, and their increased production has in turn, increased global supply levels. Despite this, Saudi Arabia and the other OPEC (Organisation of the Petroleum Exporting Countries) countries have maintained supply levels and flooded the market with oil, which has had disastrous effects to energy industry profits in all countries due to the lower price this has caused. However, if you think that the Saudis are failing to keep up with global trends and have naively continued production levels, then think again.

 

They are fully aware that lower global prices affect the most vulnerable producers in the oil industry, including US frackers who have borrowed heavily in the expectation of high future returns. The expansion of shale production through the drilling of new wells is becoming increasingly harder to justify given the diminishing profit margins – in the short-run – of the existing wells. Although Saudis would never admit to such a strategy, this could be seen as an example of predatory pricing, whereby the oil price is lowered to such an extent that more expensive producers are forced out of the market. Saudi Arabia, who can produce oil at around $5 per barrel, claim they can deal with lower oil prices for as long as eight years. This is worrying news for frackers, most of whom struggle to break even at $70 per barrel. The reality is that Saudi Arabia is happy to deal with lower prices in order to do to the shale industry what fracking does to rocks.

 

But how does this affect Britain? The cheaper price of oil puts a little extra money in all of our pockets, so in some ways will give a boost to our economy. However, much like our neighbours across the pond, our oil is also expensive to produce, and at a price of $50 per barrel, it looks as though only the largest North Sea producers Shell and BP will be close to breaking even. Oil and gas industries provide close to 450,000 jobs around the UK, but with profits plummeting it looks as though this figure is also about to take a significant hit. The problems don’t end here for the Treasury. Around £6.5 billion in tax revenue was raised from North Sea producers in 2013. Considering how vital these firms are to the British economy, George Osborne may be forced to offer tax relief in order to keep them afloat.

 

If there is one thing we can learn from Conservative rhetoric in recent years, it is that increasing the deficit is no longer an option. So, where is the lost tax revenue going to be made up? This is an issue likely to become more and more relevant if the Saudis keep this up; the perks of cheaper fuel will be long forgotten and the unblemished realities behind our struggling energy industry may come back to haunt us.

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