IB ECONOMICS: A simple explanation of falling oil prices

oil-explainer-feb-master1050The oil industry, with its history of booms and busts, is in its deepest downturn since the 1990s, if not earlier.

Earnings are down for companies that made record profits in recent years, leading them to decommission more than two-thirds of their rigs and sharply cut investment in exploration and production. Scores of companies have gone bankrupt and an estimated 250,000 oil workers have lost their jobs.

The cause is the plunging price of a barrel of oil, which has fallen more than 70 percent since June 2014.

Prices recovered a few times last year, but a barrel of oil has already sunk this year to its lowest level since 2004. Executives think it will be years before oil returns to $90 or $100 a barrel, a price that was pretty much the norm over the last decade.

What is the current price of oil?
Brent crude, the main international benchmark, was trading at around $34 a barrel on Monday.The American benchmark was at around $33 a barrel.

Why has the price of oil been dropping so fast? Why now?

This a complicated question, but it boils down to the simple economics of supply and demand.United States domestic production has nearly doubled over the last several years, pushing out oil imports that need to find another home. Saudi, Nigerian and Algerian oil that once was sold in the United States is suddenly competing for Asian markets, and the producers are forced to drop prices. Canadian and Iraqi oil production and exports are rising year after year. Even the Russians, with all their economic problems, manage to keep pumping.

There are signs, however, that production is falling because of the drop in exploration investments. Wood MacKenzie, a consulting firm, identified 68 large oil and natural gas projects worldwide, with a combined value of $380 billion, that have been put on hold around the world since prices started coming down, halting the production of 2.9 million barrels a day.Meanwhile, RBC Capital Markets has calculated projects capable of producing more than a half million barrels a day of oil were cancelled, delayed or shelved by OPEC countries alone last year, and this year promises more of the same.But the drop in production is not happening fast enough, especially with output from deep waters off the Gulf of Mexico and Canada continuing to build as new projects come online.

On the demand side, the economies of Europe and developing countries are weak and vehicles are becoming more energy-efficient. So demand for fuel is lagging a bit.

Who benefits from the price drop?
Any motorist can tell you that gasoline prices have dropped. Diesel, heating oil and natural gas prices have also fallen sharply.The latest drop in energy prices — regular gas nationally now averages around $1.76 a gallon, roughly down about 43 cents from the same time a year ago — is also disproportionately helping lower-income groups, because fuel costs eat up a larger share of their more limited earnings.Households that use heating oil to warm their homes are also seeing savings
Why Oil Is Plummeting »Who loses?
For starters, oil-producing countries and states. Venezuela, Nigeria, Ecuador, Brazil and Russia are just a few petrostates that are suffering economic and perhaps even political turbulence.The impact of Western sanctions caused Iranian production to drop by about one million barrels a day in recent years and blocked Iran from importing the latest Western oil field technology and equipment. With sanctions now being lifted, the Iranian oil industry is expected to open the taps on production soon.
In the United States, there are now virtually no wells that are profitable to drill.

Chevron, Royal Dutch Shell and BP have all announced cuts to their payrolls to save cash, and they are in far better shape than many smaller independent oil and gas producers.

States like Alaska, North Dakota, Texas, Oklahoma and Louisiana are facing economic challenges. There has also been an uptick in traffic deaths as low gas prices have translated to increased road travel. And many young Saudis have seen cushy jobs vanish.

What happened to OPEC?
Iran, Venezuela, Ecuador and Algeria have all pressed OPEC, a cartel of oil producers, to cut production to firm up prices. At the same time, Iraq is actually pumping more, and Iran is expected to become a major exporter again.

On Feb. 16, OPEC members Saudi Arabia, Venezuela and Qatar, along with Russia, announced a plan to freeze output at current levels.

The plan represents a reversal for Saudi Arabia in particular. As oil prices have slumped, the country, the de facto leader of OPEC, has avoided trying to manage the market through cuts, or even talking of them. Instead, it has continued to ramp up production, even as prices dropped sharply.

Nonetheless, if prices remain low for another year or longer, King Salman, who assumed power in January 2015, may find it difficult to persuade other OPEC members to keep steady against the financial strains. The International Monetary Fund estimates that the revenues of Saudi Arabia and its Persian Gulf allies will slip by $300 billion this year.

 

Is there a conspiracy to bring the price of oil down?
There are a number of conspiracy theories floating around. Even some oil executives are quietly noting that the Saudis want to hurt Russia and Iran, and so does the United States — motivation enough for the two oil-producing nations to force down prices. Dropping oil prices in the 1980s did help bring down the Soviet Union, after all.

But there is no evidence to support the conspiracy theories, and Saudi Arabia and the United States rarely coordinate smoothly. And the Obama administration is hardly in a position to coordinate the drilling of hundreds of oil companies seeking profits and answering to their shareholders.

When are oil prices likely to recover?

Not anytime soon. Oil production is not declining fast enough in the United States and other countries, though that could begin to change this year. But there are signs that supply and demand — and price — could recover some balance by the end of 2016.

Demand for fuels is recovering in some countries, and that could help crude prices recover in the next year or two. There is now little or no spare production capacity to give the market a cushion in case of another crisis in a crucial oil-producing country.

Link to New York Times article