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Deflationary Consequences of Oil Price Drop Will Destabilize Global Economy

Few people would argue against the deflationary impact of lower commodity prices – especially oil. In Oklahoma City, the price of a gallon of gas slumped below $2 last week, creating long queues as gas stations competed to offer the lowest price. The last time anything like this occurred was way back in the 1960s and 70s.

The race to the bottom is not only being fought at your local gas station. With commodity prices such as iron ore in a virtual free fall, the currencies of resource dependent exporting nations such as Australia have been plummeting as well.

Russia, whose economy is largely dependent on oil exports, has seen its ruble drop by 37% this year. Coupled with Western sanctions, these events have shaken the very foundations of the nation’s economy. Oil exporting nations such as Iran, Iraq, Nigeria, Venezuela and Mexico are also feeling the impact which is certain to destabilize the entire global economy.

OilPriceSlump2Japan has inaugurated another massive program of quantitative easing in an effort to create inflation while the nation slips into another recession. Europe is also facing deflationary pressures and calls for quantitative easing are growing.

The implications for U.S. shale producers of lower oil prices are ominous indeed. Patricia Mohr, an economist at Scotiabank, estimates an average break-even price in the Bakken and Permian basins of around $69 a barrel, while noting costs for individual wells can range from $54 to $82 a barrel. Many of these wells have been funded by low interest debt and high risk junk bonds.

The end of the shale boom might well be near, according to some analysts. What the market generally fails to recognize about shale oil is the fact that production rates can drop by as much as 70% in the first year, meaning that companies have to drill increasingly more expensive wells in less attractive areas just to maintain production rates.

The euphoria about US oil independence, along with the prospects for exporting oil to foreign markets, could soon come to an end as the realities of the marketplace hit home. Obama’s obstructionist policy towards Trans Canada’s Keystone pipeline, which will probably not receive the go-ahead under his leadership, might well come back to haunt future administrations.

In fact, Canada is now considering an alternative route for the pipeline to its east coast. This would offer Canada alternative markets for its oil output and no doubt give it leverage to increase prices in US markets in the future.

One key advantage oil sands producers have over their shale competitors is the fact that production levels are consistent throughout the life of the oil sands resource. There is no reduction in production levels over time. It won’t happen overnight but the US will one day recognize the strategic importance of Canada’s vast oil sands resources which rival and possibly exceed anything in the Middle East.

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