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An oil pump jack pumps oil in a field near Calgary on July 21, 2014. (TODD KOROL/REUTERS)
An oil pump jack pumps oil in a field near Calgary on July 21, 2014. (TODD KOROL/REUTERS)

Why oil prices are dropping despite Mideast unrest Add to ...

Canada’s oil patch is basking in an extended sweet spot of sorts. Commodity prices aren’t spiking in a way that’s sure to sink the global economy, nor are they plumbing depths that would force small producers out of business and big players to start tightening their belts and cutting jobs. The global oil market, however, is changing and nowhere are the signs more evident than the reaction to what’s happening in the Middle East.

In the past, military conflicts in the Middle East and the attendant threat of supply disruptions would send oil prices soaring. Today, oil prices are falling even as the region is seemingly unraveling. Civil wars are unfolding in Iraq, Syria, and Libya, atrocities by ISIS have the western world mounting military action, and Hamas and Israel are coming off arguably the most intense period of conflict in years. The region feels like a tinderbox. Oil supply has already suffered in Libya and Iraq and the threat of production losses is looming over other countries in the region.

Historically, such widespread unrest would have caused global oil prices to march higher, but instead of rising against the backdrop of heightened geopolitical risks, Brent, the global price benchmark, has recently sunk below $100 a barrel. Despite the unrest in the world’s most important oil producing region, the price of Brent is now actually 16 percent lower than it was in June.

On one hand, the world’s major oil consuming economies can let out a big sigh of relief. In the past, oil shocks emanating from the Middle East have led to devastating recessions. For investors in oil companies, though, the recent retreat in global crude prices raises a different question. If crude can’t rally on what’s happening in the Middle East, then what will it take to move prices higher? Does today’s disconnect between global oil markets and the chaos that’s gripping the region signal an end to the era of triple digit oil prices? If so, what are the consequences for North America’s oil industry?

According to U.S. shale producers, it’s the prolific production from the Bakken and the Eagle Ford that’s taken the edge away from OPEC’s market clout. Thanks to the contribution from unconventional plays, U.S. oil production is threatening to surpass the output from Russia and even Saudi Arabia. Although current U.S. law prohibits raw crude from being sold abroad, the sale of 3.5 million barrels a day of refined products such as gasoline and diesel is, ostensibly, helping to keep a cap on the price of oil elsewhere in the world.

It’s a cute theory, but the real reason global oil prices are falling doesn’t have much to do with a bump in the amount of refined products that are being exported from the U.S. In actuality, it’s the same reason that coal prices have been cut in half over the last two years — demand is no longer increasing at the rate it once was.

U.S. oil consumption, by far the largest in the world, has recently fallen to 18.6 million barrels a day, down from nearly 21 million prior to the last recession. European oil demand peaked more than 20 years ago and has fallen in each of the last five years. Even China’s thirst for oil is diminishing as economic growth there shifts into a lower gear. The country’s latest industrial production numbers were the weakest since 2008. Indeed, global oil demand forecasts are being cut by nearly everyone in the business, whether it’s the International Energy Agency, the U.S. Energy Information Agency or even OPEC.

If the trend towards weakening demand growth continues, there’s only one direction for oil prices to go. It’s the same direction that coal prices have already went. Newcastle spot prices, essentially the global benchmark price for coal, have fallen from a peak of more than $140 a ton in early 2011 to less than $70 a ton.

Tumbling prices have wreaked havoc in the industry. Coal companies have gone bankrupt, mines have closed and investors have seen their portfolios decimated. Since early 2011, coal giants such as Peabody Energy and Arch Coal have shed more than 80 per cent of their market value. If crude prices end up mimicking their fossil fuel cousin, prices could be heading as low as $40 to $60 a barrel in the not-too-distant future.

For the moment, it might seem like North America’s unconventional production has relegated OPEC to the sidelines. That can easily happen in a world of $100 oil, because such high prices offer enough incentive for producers to bring on new supplies from expensive sources such as the Bakken or Alberta’s oil sands. In a world of falling prices, however, it will be high cost production from shale formations and the oil sands, not the low cost conventional crude from places such as Saudi Arabia and Iran that will be hit the hardest. Investors in North America’s oil sector need to ask themselves what happens when lower prices make those plays uneconomic.

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