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Declining Oil Price in The Global Market

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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