The price of Brent Crude has fallen by more than half — from $115 a barrel in June to around $40 last week and the financial company Goldman Sachs thinks that it will fall below $20. This comes after a period of relative stability since around 2010. Currently, the nominal price is almost touching its post-crisis low in March 2009 (Chart 1). This price collapse has triggered debate on the factors responsible for the precipitous decline.
Oil Price Determination:-
The oil price is partly determined by actual supply and demand, and partly by expectation. Demand for energy is closely related to economic activity. It also spikes in the winter in the northern hemisphere, and during summers in countries which use air conditioning. Supply can be affected by weather (which prevents tankers loading) and by geopolitical upsets. If producers think the price is staying high, they invest, which after a lag boosts supply. Similarly, low prices lead to an investment drought. OPEC’s decisions shape expectations: if it curbs supply sharply, it can send prices spiking. Saudi Arabia produces nearly 10m barrels a day—a third of the OPEC total.
Four things are now affecting the picture. Demand is low because of weak economic activity, increased efficiency, and a growing switch away from oil to other fuels. Second, turmoil in Iraq and Libya—two big oil producers with nearly 4m barrels a day combined—has not affected their output. The market is more sanguine about geopolitical risk. Thirdly, America has become the world’s largest oil producer. Though it does not export crude oil, it now imports much less, creating a lot of spare supply. Finally, the Saudis and their Gulf allies have decided not to sacrifice their own market share to restore the price. They could curb production sharply, but the main benefits would go to countries they detest such as Iran and Russia. Saudi Arabia can tolerate lower oil prices quite easily. It has $900 billion in reserves. Its own oil costs very little (around $5-6 per barrel) to get out of the ground.
Generally, supply-demand balance is provided as the cause for the decline of oil prices as the global recession and weakening of growth in most economies especially in China lowered the demand for crude oil. However, this has some role in this but statistics shows that from February 2011 to August 2014, the price of Brent Crude Oil was above $100 a barrel despite having the global recession.
Second explanation is related to the excess supply of Shale Gas resulting from the shale oil and gas production boom in the US that has reduced the import demand from the US market. The US alone has added around 4 million barrels of crude a day to the total global supply of around 80 million barrels a day. But the boom has been underway for sometimes now, and while an important explanation for low prices, is an inadequate explanation for the sudden price collapse.
Other Possible Explanations:-
● One possible explanation for the speed of adjustment of prices in the face of medium term supply-demand imbalances is that those speculating that oil prices would remain at long-term highs despite the changing market situation were taken by surprise when prices did begin to fall. These agents must have gained confidence in their predictions when war and political instability in Iraq and Libya, and elsewhere in West Asia, did not affect the combined production of the region too adversely.
Moreover, based on past experience, they were betting on the fact that if prices do slip, the traditional ‘swing producer’ Saudi Arabia would cut production and adjust the supply-demand balance to prevent or moderate the fall. Accounting for nearly 10 million barrels a day or a third of OPEC production, which accounts for around two-fifths of total supply, the swing producer in the past has periodically adjusted production to manage prices. However, in November OPEC meeting, Saudi Arabia declined to cut production for fear of losing market share to new producers like Shale oil and gas producers of North America. Since its production costs are placed at as low as $5-$10 a barrel, which insures it against losses even at very low prices. With the Saudis not relenting, the oil glut persists, speculators have taken a major hit and the price of oil has spiralled downwards.
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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