Will global oil prices stay low?

Will global oil prices stay low?

 

This is very hard to predict. If oil demand remains weak and production stays high, prices might not bounce back for some time.

Global oil prices have fallen sharply over the past months, leading to significant revenue shortfalls in many energy exporting nations, while consumers in many importing countries are likely to have to pay less to heat their homes or drive their cars.

But the world is full of potential surprises. Conflict could break out again in Libya or Iraq, which would hamper oil production. China's economy could come roaring back. Europe could suddenly rebound out of its malaise. Saudi Arabia could decide that enough is enough and cut back on production all of the sudden. Any of those things could increase prices.

But why does the price of oil keep falling? Back in June 2014, the price of Brent crude was up around $115 per barrel. As of January 23, 2015, it had fallen by more than half, down to $49 per barrel.

The reasons for this change are twofold - weak demand in many countries due to insipid economic growth, coupled with surging US production.

Added to this is the fact that the oil cartel Opec is determined not to cut production as a way to prop up prices. 

Why oil prices plummeted in 2014

 

To understand this story, we first have to go back to the mid-2000s. Oil prices were rising sharply because global demand was surging — especially in China — and there simply wasn't enough oil production to keep up. That led to large price spikes, and oil hovered around $100 per barrel between 2011 and 2014.

Yet as oil prices increased, many energy companies found it profitable to begin extracting oil from difficult-to-drill places. In the United States, companies began using techniques like fracking and horizontal drilling to extract oil from shale formations in North Dakota and Texas. In Canada, companies were heating Alberta's gooey oil sands with steam to extract usable crude.
This led to a boom in "unconventional" oil production. The US alone has added 4 million extra barrels of crude oil per day to the global market since 2008. (Global crude production is about 75 million barrels per day, so this is significant.)

Up until very recently, however, that US oil boom had surprisingly little effect on global prices. That's because, at the exact same time, geopolitical conflicts were flaring up in key oil regions. There was a civil war in Libya. Iraq was facing threats from ISIS. The US and EU slapped oil sanctions on Iran and pinched its oil exports. Those conflicts took more than 3 million barrels per day off the market

By mid-2014, however, those outages and conflicts were no longer quite as important. Production in the United States and Canada was still rising fast — and the world's supply of oil kept growing.
That combination of weaker-than-expected demand and steadily rising supply caused oil prices to start dropping from their June peak of $115 per barrel down to around $80 per barrel by mid-November.

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 six 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.

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

OPEC

 

That brings us to OPEC, a collection of oil-producing nations that pumps out about 40 percent of the world's oil. In the past, this cartel has sometimes tried to influence the price of oil by coordinating either to cut back or boost production.

At its big meeting in Vienna on November 27, there was a lot of heated debate among OPEC members about how best to respond to the drop in oil prices. Some countries, like Venezuela and Iran, wanted the cartel (mainly Saudi Arabia) to cut back on production in order to prop up the price. These countries need high prices in order to "break even" on their budgets and pay for all the government spending they've racked up.

On the other side of the debate was Saudi Arabia, the world's second-largest crude oil producer, which was opposed to cutting production and seemed willing to let prices keep dropping.
Why was that? For one, officials in Saudi Arabia remember what happened in the 1980s, when prices fell and the country tried to cut back on production to prop them up. The result was that prices keptdeclining anyway and Saudi Arabia simply lost market share. What's more, the Saudis have signaled that they can live with lower prices in the short term. 
 
SAUDI ARABIA WAS IN FAVOR OF LETTING PRICES CONTINUE TO FALL

In the end, OPEC couldn't quite agree on a response and ended up keeping production unchanged. "We will produce 30 million barrels a day for the next 6 months, and we will watch to see how the market behaves," said OPEC Secretary-General Abdalla El-Badri after the meeting.
That caused the price of oil to start crashing even further. The price of Brent crude went from $80 per barrel to $70 per barrel in just a few days. And it kept tumbling to down below $60 per barrel by mid-December and $50 by January.

For all intents and purposes, OPEC is now engaged in a "price war" with the US. What that means is that it's relatively cheap to pump oil out of places like Saudi Arabia and Kuwait. But it's more expensive to extract oil from shale formations in places like Texas and North Dakota. So as the price of oil keeps falling, some US producers may become unprofitable and go out of business. And the price of oil will stabilize. At least that's what OPEC members hope.

So who are some of the winners and losers?

Russia

Russia is one of the world's largest oil producers, and its dramatic interest rate hike to 17% in support of its troubled rouble underscores how heavily its economy depends on energy revenues, with oil and gas accounting for 70% of export incomes.

Russia loses about $2bn in revenues for every dollar fall in the oil price, and the World Bank has warned that Russia's economy would shrink by at least 0.7% in 2015 if oil prices do not recover.

Venezuela

 

Venezuela is one of the world's largest oil exporters, but thanks to economic mismanagement it was already finding it difficult to pay its way even before the oil price started falling.
Inflation is running at about 60% and the economy is teetering on the brink of recession. The need for spending cuts is clear, but the government faces difficult choices.
The country already has some of the world's cheapest petrol prices - fuel subsidies cost Caracas about $12.5bn a year - but President Maduro has ruled out subsidy cuts and higher petrol prices.

Saudi Arabia

 

There's no question that Saudi Arabia, the world's second-largest crude producer (after Russia), will suffer financially from cheap oil. If oil stays at around $60 per barrel next year, the government will run a deficit equal to 14 percent of GDP.

There could be two reasons - to try to instill some discipline among fellow Opec oil producers, and perhaps to put the US's burgeoning shale oil and gas industry under pressure.
Although Saudi Arabia needs oil prices to be around $85 in the longer term, it has deep pockets with a reserve fund of some $700bn - so can withstand lower prices for some time.
"In terms of production and pricing of oil by Middle East producers, they are beginning to recognise the challenge of US production," says Robin Mills, Manaar Energy's head of consulting.

United states

In the US, meanwhile, a fall in crude prices will have both positive and negative impacts. For many people, it will offer an excellent economic boost: cheaper oil means lower gasoline prices - which have fallen to $2.04 per gallon, the lowest since 2009

If the price drop lasts a long time, that could also spur people to start using more oil. Case in point: In recent years, high gasoline prices have spurred many Americans to buy smaller, more efficient cars. But if gasoline prices fall, bigger cars and SUVs could make a comeback.

Iran

 

Iran's economy had recently started to rebound after years of recession. The International Monetary Fund had been projecting that the country was on track to grow 2.3 percent next year. But that was all before oil prices started to plunge — a potentially precarious situation for the country.

One big problem for Iran is that it also needs oil prices well north of $100 per barrel to balance its budget, especially since Western sanctions have made it much harder to export crude. If oil prices keep falling, the Iranian government may need to make up revenues elsewhere — say, by paring back domestic fuel subsidies.

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