The sequester\s reduction in government oil subsidies will bring energy prices on par with other countries: higher than today

STEVE AUSTIN | 2013/03/18

Well, March arrived with 'the sequester,' didn't it? As you heard, on March 1, 'the sequester' swung into action with President Barack Obama signing an order to bump away $85 billion from the budget of Government agencies between March 1 and October 1, 2013. If there lurked some hope of a different budget plan with last-minute resolutions, what a pipe dream it turned out to be. Truth be told, the cuts in spending can axe away almost 0.5 percent from the economic growth of the months leading to October, according to the International monetary fund. To put things in perspective, unemployment figures have just showed signs of recovery. Nailed is the word.

So what's in it for Oil and US?

Well, before that what's "the sequester"?

Dubbed 'the sequester', it is, in reality, spending cuts spread over a period of ten years, frantically slashing almost $1.2 trillion from military and domestic programs of the government. You'd have heard of $85 billion which is, to be clear, the amount taken off from this year's spending programs. The President did meet the Congressional leaders to avert this cliff through a combo of tax rises and spending cuts. Well, a radical 'saver deal' didn't happen and 'the sequester' is in place. Versus a saver deal, the serrating effects of sequester is quicker. Yet, speaking in terms of a nations's growth story, the effects would be slow. Equally tedious are the words of the President on the sequester, "If the sequester is allowed to go forward, thousands of Americans who work in fields like national security, education or clean energy are likely to be laid off. Firefighters and food inspectors could also find themselves out of work" Directly affected, in short and long-term perspective, are the defense sector and companies dependent of federal funds.

If you're a regular reader you know topics we cover are never black or white. Same goes with this one. There are many factors at play that will pull oil prices one way or the other. Today we try our best to lay out the factors that play and explain what will happen.

Factors that will make oil cheaper

Lesser energy consumption by US Government. In fact, the US government doesn't have any choice but to be frugal in consumption. (Indeed, one measure to know this: The number of public sector workers fell by 10,000 in February. So, fewer people to spend on.)

Lesser energy consumption by private companies dependent on US Government spending. With money earmarked for these companies drying up, many of their projects will slow down leading to lesser energy consumption. Of course, it would have been preferable to have companies that use less energy without the enforced 'sequester' doing the trick, but as things stand this is how economy moves in the world dictated by oil. From a tangential point, remember: the United States is the world's largest consumer of oil.

The military cuts means less consumption by military. US Navy is largest oil consumer in US, so this is bound to affect oil prices too.

Lower economic activity (airline travels, import of goods, industrial production etc....) can translate into lesser demand for oil. (Did you cancel your vacation plans too?)

Wall Street is bidding on oil price to fall. That's what the "smart money" thinks. (What do you think... so far?)

Lesser demand. One of the main reasons: There just isn't enough physical demand to warrant higher oil prices. Also, there's healthy supply. According to the Energy Information Administration (EIA), the total oil inventories are up by almost nine percent from the levels year ago. Reportedly, crude oil inventories rose to the tune of 1.1 million barrels in the week. Also, the domestic production has increased due to shale drilling. The price of crude oil fell in anticipation of the sequester, the week post the announcement as well. Taking demand and supply under consideration, in the short-term, the oil prices will not rise as you expect because: a. the demand is weak. b. the supply is healthy.

Economic situation in the US. According to Bureau of Economic analysis, personal income decreased 3.6 percent ($505.5 billion) in January, while disposable personal income decreased 4.0 percent ($491.4 billion). On the unemployment front, the Labor department announced that 236,000 jobs were added in February. Thus, unemployment rate dropped to 7.7 percent from 7.9 in January, hitting a four- year low. Despite these figures, with spending cuts, analysts fear that the gains achieved could face challenges in the wake of the spending cuts.

slow growth in China. Economic growth in China is weak (Aside: Even in Europe-sluggish growth in March cast fears on Euro Zone recovery). In 2012, reports suggested that China accounted for almost forty percent of global oil demand and ten percent of world's oil consumption. It now emerges that those figures were a tad over estimated (Did they take us for a ride?). Taking into account the increase in refineries in the country, as well as other factors, even the International Energy agency (IEA) has changed its methodology to calculate energy demand in China. Anyway, China is slowing moving towards natural gas which could, in turn, reduce demand. Of course, natural gas is cleaner and cheaper than gasoline and diesel. Noting other parameters, the latest official Purchasing Managers' Index (PMI) in China came in at 50.1 from 50.4 a month earlier. China's services sector hit its slowest pace of a five month period, in February. Factory growth has slowed down too. Thus, the Economic growth data from the Asia giant shows signs of 'cooling' which could lead to lower global oil consumption.

Factors that will make oil more expensive

Oil companies get a lion's share of Federal energy subsidies. In fact, it's hard to give oil companies more subsidies than they already get, either directly or through preferencial fiscal imposition. There's a silver lining to this: partly thanks to government subsidies, US consumers have enjoyed the lowest gas prices in the western world for decades. European consumers often pay twice as much as US consumers for the same gallon of gasoline. So as you've guessed, these subsidies will only go down. In order to secure the same profits, oil companies will have to increase prices. If the company is involved in the extraction then this increase will affect oil prices. If the company is involved in the distribution then this will rather influence gas prices instead.

On the Economic front, the government has released optimistic economic data. The U.S. purchasing managers index (PMI), rose to 54.2 in February from 53.1 the previous month. This is the highest since June 2011. Manufacturing not only grew but expanded too. Production climbed to 57.6 from 53.6 percent in January. Consumer spending rose too by 0.2 percent. Taking all this under consideration, if demand picks up so should the price of oil.

Lesser consumer spending on green energy. Green energy, at least in the bootstrapping stage they're now in, cannot currently compete on cost with oil. Solar panels, hybrid vehicles are large upfront investments that pay off in the long to very long-term. If the purse is tight, these will go and demand for equivalent petroleum-derived products will increase. Add to this the "hip" factor of being green. Trends change quickly and the green revolution may stall and being frugal is in.

Lower budgets means less Government incentives for sponsoring green energy endeavors. Most green energies are not viable without Government subsidies. Consequently many subsidies-dependent projects may have to go dormant.

Sequester will slow approval process of federal drilling. Think of the North Dakota revolution we covered. These projects will slow down. Already, new permits for oil drilling are hard to come by, post the infamous Deepwater Horizon incident of 2010. Oil experts, including ourselves believe that the spending cuts would make it -even- more difficult for oil companies to receive permits for drilling on Federal land. Say, there're more than one way to do that via environmental clearance and reviews. Exempting production from shale gas, the administration can now, conveniently, blame the sequestration for any lag in production from Federal soil. For instance, more than five hundred oil and gas projects in the Gulf of Mexico will join the queue for oil and gas leases.

According to a report by the Congressional Research Service, crude oil production, on private and state lands increased between fiscal 2007 and fiscal 2012 but production on federal lands fell by about seven percentage points. In the case of gas, production on federal lands, both onshore and offshore, fell by a whopping 33%. We all love the President for his penchant for renewable but how long would you rob Peter to pay Justin? Anyway, as we hinted earlier, funding for renewable energies are going to see a hard phase, thanks to the spending cuts. What are we left with?

So, we have put the cards on the table. Basically, an 'egg' or 'chicken' first situation, though we have put in enough clues. If you are still confused, keep watching this space for our conclusion. In other words, come back.