Premium #202 – How Oil Production Costs Impact Aviation

As oil prices slump, there are a number of sources that offer explanations of what might happen. The IMF has a good one, as does Chase. Generally there is a concern that major oil source nations in the Middle East need expensive oil to ensure their budgets stay balanced. Failure to do this will eventually lead to a financial crisis, and as we have seen, all crises in the Middle East cast long shadows. Actually, a number of key oil producing nations outside the Middle East are also in unsettled conditions; Venezuela, Nigeria and Angola come to mind. Of course oil consuming nations are pleased as lower oil prices are an economic stimulus. The problem for the oil market is that the fine balance that existed to date is now way out of balance. Demand from western nations has fallen from improved energy efficiency and growing green energy (wind & solar) use. Moreover, a key oil consuming nation, the United States, has deployed technology to increase its own oil production. Exacerbating the problem is the fact that oil producers in OPEC want to undermine the rising US production and are trying to hold market share at all costs. Keeping supply high and forcing prices lower is supposed to wash out high cost US producers. It's not happening yet, even though many US fracking firms are closing down. Certainly many producing firms have stopped exploration and developing new wells. But a lot of the "new" production is still coming to market. Some producers are so desperate they want to give away their oil. Watch this: Meanwhile many traditional oil suppliers are having a tough time. Russia has seen its currency decline sharply. The BBC notes: "Russia loses about $2bn in revenues for every dollar fall in the oil price, and the World Bank has warned that Russia's economy would shrink by at least 0.7% in 2015 if oil prices do not recover." Meanwhile Russia needs to finance a war in Syria and restless allies in the Donbass. Plus it needs to keep its own population fed and employed. Venezuela is a mess as the link above explained. Its still unclear how the recent elections will play out. Will the country recover without violence? No matter who is in charge they will pump all the oil they can to get cash. Middle East - big things are happening here. Saudi Arabia used to be the swing producer until the American frackers emerged. Saudi has an expensive war in Yemen, plus a war next door in Syria and Iraq, and a growing friction with Iran. Iran is about to reenter the oil market supply, too. Every nation in the region needs to sell as much oil as possible to keep restive populations quiet - and keep their military assets updated. (To make things really interesting, Israel is now an energy producer adding to the supply) Turkey is now trying a rapprochement with Israel in order to decrease its dependence on Russian energy. How about that for a switch? Meanwhile Iraq and Libya are trying to get their own oil production back up because they need cash, too. As a chart in the BBC link shows, all these nations are in big trouble when one looks at the oil price and the price needed by these nations to balance budgets. Africa - Nigeria's production should make the nation wealthy, but corruption keeps it poor. Nothing on the horizon looks like changing that. Angola is also a sizable producer. But as cheaper oil impacts its economy, Angola has its traditional way of fixing things. The next chart illustrates the extent of the challenge being faced by producers. It is not a great picture for producers. There is too much oil being produced. And it looks like producers cannot, and will not, stop. Where does this leave us? Biofuels were all the rage recently and now we expect to hear less about that. The green movement is being derailed by its high relative costs to oil. As oil prices stay low, we expect to see consumption go up across the broad. Already in the US there is a noticeable change in automobile purchases. Electric cars, having attracted a lot of attention, are likely to attract fewer buyers. You can now lease a Chevy Volt cheaply, as they simply aren't selling, even with a nice tax credit in the process. The timing on lower oil prices is really awkward for the Global Warming crowd. Everything has become more energy efficient in recent years, from cars to appliances, which supply has grown for alternatives such as natural gas, and additional capacity through fracking. The supply-demand balance has changed, and those changes are structural and probably permanent. Given the focus of traditional players on maintaining market share, we are likely to see overproduction continue, particularly since lack of production results in economic and social instability that could, ultimately, lead to regime change in some Middle Eastern countries in a worst case scenario. With a feasible five year period of low oil prices ahead, we expect to see next generation aircraft deliveries to be moved to the right. The first airlines we expect to do this will be those based in the Middle East, especially the Gulf. There are reports Saudi Arabia wants to sell its national airline. The only possible bright spot for aircraft sales in the region is Iran - but it may want to hold on to its assets once they are unfrozen. It might not be smart to spend too much of its unfrozen cash on up to 500 aircraft as sanctions are lifted. Will we see some delivery positions for other oil producing countries end up in Iran? Expect to see the first order deferrals from the Middle East in mid-2016, as traffic will be down given local economic impacts, and most of that will be premium class oil industry traffic that provides profitability for long-haul international flights. The aircraft OEMs will try to keep orders deferred rather than cancelled, but in the end, we foresee some cancellations if the supply-demand balance for energy remains in a prolonged oversupply condition. Things are not looking good for Middle East economies for the near future, which could lead to additional political and social instability in an already troubled region. And the Airbus and Boeing backlogs are exposed (dependent?) to these economies.

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