The snakes come out in the oil market

One of the classic board games of all time is Snakes and Ladders. It’s great fun for the whole family because no one has any advantage over the other players, it’s completely a game of chance. You roll the dice and hope for the best.

Alberta finds itself in a perpetual game of snakes and ladders with commodity prices: we’re a price taker. What drives oil prices higher and lower depends on a complex series of international factors—the ladders and snakes—over which we have no control.

Lately, it appears the snakes are gaining the upper hand.

The price of the North American benchmark West Texas Intermediate trading on the New York Mercantile Exchange (NYMEX) closed Wednesday at $89.90 U.S. per barrel—the lowest price since October of last year. Price recovered a small amount on Thursday, but on Friday morning the price was still trading only slightly above $90 U.S. per barrel.

Alberta obviously has a lot at stake.



More snakes than ladders!

The provincial government based its recent budget on oil prices averaging $99.25 per barrel. As well, some of the

large oilsands producers—which are driving much of the investment and activity in the province—have assumed prices will average above $100 per barrel.

What’s behind the sagging oil price? The one big snake on the game b oard at the moment is Europe.

With the ongoing government debt crisis going from bad to worse in countries like Greece, Spain, Italy and Portugal, the future of the entire Euro region is in question. Of particular concern is the unresolved leadership question in Greece.

In the next few weeks, Greeks will go back to the polls to elect a government—but it appears the likely winner of that election will pull Greece out of its austerity agreements with Germany. If that happens, Germany and other countries which have been bailing out Greece may decide the party is over. And if that happens, a Greek government default could be inevitable.

This has placed a cloud of worry over the future of the global economy. European banks are exposed to a lot of that Greek, Spanish and Italian government debt. If there is to be a collapse of confidence in Europe’s banks, it would quickly spread into a general credit market crisis around the world—banks everywhere will be reluctant to lend lest they end up on the wrong end of deal gone bad. This seizure in credit markets is precisely what happened in 2008, except then it was the collapse of American banks. This year it could be Europe’s turn.

That’s the worst case scenario. A major credit market crisis and another global recession are still unlikely, yet the probability of it happening has risen a bit this month. If the European and American economies are to slow down, drivers and industries will be buying much less fuel. And in turn, investors have bid down the price of crude oil.

Another snake dragging down oil prices is China. This economic giant has been largely responsible for propping up the global economy lately, especially with its nearly insatiable appetite for commodities such as oil, base metals and agricultural products. However, signs of an economic slowdown in that country have added to the worries that the global economy may be slowing. If we lose China to an economic downturn, all bets are off for commodity prices.

There are still some ladders on the game board that could help move oil prices higher. The Middle East is a significant source of supply for the global economy and tensions and violence in that region could threaten that supply. This was the most important factor in pushing the European benchmark price for oil well above $125 U.S. earlier this year. However, tensions in the Middle East—or more precisely, the media’s attention to them—have abated for the time being. This has made the ladder a bit shorter in recent weeks.

Oil prices may be under the influence of the snakes at the moment, but there is probably a limit to how far prices will fall. The cost to producers to extract the last barrel of oil coming out of the ground (what economists call the “marginal cost”) is estimated to be around $ 75-95 U.S. per barrel. Producers start losing money if prices fall much below that so they start to limit production. That in turn adds some price support. Barring a complete collapse to the global economy, it’s hard to imagine oil prices falling much below that $75 price floor for too long.

Much hangs in the balance for Alberta. Another repeat of 2008—which saw oil prices plunge to $33 U.S. per barrel momentarily—would jeopardize the provincial economy and wipe out the government’s hope to balance the budget. But the probability of that happening remains slim. But in the end, it’s a game of Snakes and Ladders.