The price of Brent Crude has fallen by more than half—from
$115 per barrel in June to around $40 last week—and the financial firm Goldman
Sachs predicts it could drop below $20. This decline follows a period of
relative stability since 2010. At present, the nominal price is nearing its
post-crisis low from March 2009 (Chart 1). This sharp price collapse has
sparked debate over the factors driving this steep decline.
Oil Price Determination:-
The price of oil is influenced by both actual supply and
demand as well as market expectations. Energy demand is closely tied to
economic activity, with seasonal spikes occurring in the winter across the
northern hemisphere and during summers in countries reliant on air
conditioning. Supply, on the other hand, can be disrupted by weather conditions
that prevent tanker loading and by geopolitical instability. When producers
anticipate sustained high prices, they invest in expanding production,
which—after a lag—boosts supply. Conversely, prolonged low prices lead to
reduced investment. OPEC's decisions also shape market expectations; if it
significantly curtails supply, prices can surge. Saudi Arabia, producing nearly
10 million barrels per day—about a third of OPEC’s total—plays a key role in
this dynamic.
Currently, four factors are influencing the oil market.
First, demand remains weak due to sluggish economic activity, improved
efficiency, and a growing shift toward alternative fuels. Second, despite
ongoing turmoil in Iraq and Libya—two major producers with a combined output of
nearly 4 million barrels per day—their oil production has remained largely
unaffected, leading to reduced geopolitical risk perception. Third, the United
States has emerged as the world’s largest oil producer. While it does not export
crude oil, its reduced import dependence has freed up significant global
supply. Lastly, Saudi Arabia and its Gulf allies have opted to maintain their
market share rather than cut production to stabilize prices. Although they
could reduce output sharply, the primary beneficiaries would be rivals like
Iran and Russia. Saudi Arabia, however, can withstand lower oil prices with
ease, given its $900 billion in reserves and the low extraction cost of its
crude, estimated at just $5–6 per barrel.
The decline in oil prices is often attributed to the
supply-demand balance, with the global recession and slowing economic
growth—particularly in China—reducing the demand for crude oil. While this
factor has played a role, it does not fully explain the price drop. Notably,
from February 2011 to August 2014, despite the lingering effects of the global
recession, Brent Crude Oil prices remained above $100 per barrel. This suggests
that other factors beyond weak demand have contributed to the recent decline.
A second explanation points to the excess supply of shale
gas, driven by the shale oil and gas production boom in the United States,
which has significantly reduced U.S. import demand. The U.S. alone has added
approximately 4 million barrels of crude oil per day to the global supply,
which stands at around 80 million barrels per day. However, while the shale
boom is an important factor in the decline of oil prices, it has been underway
for some time. Thus, it alone does not adequately explain the sudden price
collapse.
Other Possible Explanations
One possible explanation for the rapid adjustment of oil
prices in response to medium-term supply-demand imbalances is that
speculators who had anticipated long-term high prices were caught off guard
when prices began to fall. These speculators had gained confidence in their
forecasts when geopolitical instability in Iraq, Libya, and other parts of West
Asia did not significantly disrupt oil production.
Additionally, based on historical trends, they expected
Saudi Arabia—the traditional "swing producer"—to intervene by cutting
production to stabilize prices. With Saudi Arabia accounting for nearly 10
million barrels per day, about one-third of OPEC’s production (which itself
supplies around two-fifths of global oil), the country has historically
adjusted output to influence prices. However, in its November meeting, OPEC,
led by Saudi Arabia, opted not to cut production, fearing a loss of market
share to new producers, particularly the shale oil and gas industry in North
America. Given that Saudi Arabia's production costs are as low as $5–$10 per
barrel, the country remains insulated from losses even at significantly reduced
prices. As a result, the ongoing oil surplus, combined with speculative
miscalculations, has led to a steep decline in prices.
Effects: -
Negative Effects on Market:-
● A price decline of this kind is bound to restructure
the industry. Higher cost producers would be forced to exit. The immediate
impact is expected to be on the shale oil and gas industry in the US, where a
number of higher cost producers are expected to be forced out of production.
● Despite claims to the contrary, a significant part of
the fracking (hydraulic fracturing) industry is likely to turn uncompetitive.
● For those who have borrowed hugely to exploit the
shale boom, this could badly damage balance sheets. Shale stock prices are
falling, and bankruptcies are expected. This is expected to impact adversely
also on the banks that lent to them. Besides shale fields, projects involving
drilling in deep water, in the Arctic and in the North Sea (where low cost
sources have already been exploited) could also face problems, and cut
operations or even close. So as it stands now, a massive supply side adjustment
is in the offing, unless Saudi Arabia relents and settles for a lower market
share.
Positive Effects:-
● Consumer would benefit hugely from lower oil prices.
The saving that those lower prices would deliver would boost demand for other
goods and services, which can help the effort of pulling the world economy out
of recession.
● Lower oil prices also imply lower inflation,
especially since oil is a direct or indirect input into most commodities. Low
inflation would encourage central banks to adopt a low-interest rate and loose
monetary policy stance. Since the price decline is large, these effects can be
strong enough to deliver much-needed growth with low inflation.
Effects on Governments of Oil Producing Countries:-
● A set of estimates from Deutsche Bank and the IMF, of
the level of the oil price at which the budgets of the selected countries would
balance. It moves from $77 a barrel in Qatar to $131 in Iran and $184 in
Libya. Thus, while the media has been focusing attention on Iran,
Venezuela and Libya, there would be many more countries whose budgets are
adversely affected.
● Finally, the impact that the unwinding of the shale boom in the US would have is still uncertain. While the fallout of low oil prices for US consumers is positive, that is not the case for US businesses that invested in shale and for the banks that lent to them.
Put together these factors could have a neutralising influence on the gain from low oil prices. So the net effect for the global economy is still unclear. That could explain the initial puzzling ‘market’ reaction to the oil price decline.
(References :- C. P. Chandrashekhar and Jayanti Ghosh's work
and reports on The Economists)
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