Falling OIl Price Dynamics

Posted in Finance Articles, Total Reads: 1618 , Published on April 21, 2015

Mr Steve is planning a long road trip with his family this weekend to North Carolina for a get together. When asked why did he chose a road trip over the normal rail route to the city he gleefully answered, “Mate ! Look at the oil prices. I couldn’t resist myself to drive with such cheap oil rates”. This is what the United States along with the rest of the world is facing today: Oil Price break. The price cut down in oil has lead to more road trips and travelling and has added a high extra figure to the general household of the United States itself giving them higher purse power to spend.

Image Courtesy: freedigitalphotos.net, num_skyman

How is the once spiraling oil prices now succumbed to as low as $6o per barrel? Is it a onetime low? Shall the prices brace up and rise back to haunt the people?

A glimpse back into the not-so-far past shall inform us that not far away in June 2014 oil prices were soaring at $115 per barrel. This soar was primarily because of high demand on account of greater consumption in China and conflicts in key oil nations. China on account of its expansionary and developmental measures was the biggest importer of oil. The key oil nations were caught up in crisis. Libya was in a Civil War. Iraq was in a mess. US and EU slapped sanctions on Iran and all of a sudden on account of these 3 billion barrels of oil was taken off market. Oil production thus couldn’t keep pace with the demand and it lead to price spike. This was a honeymoon time for the major oil nations. Russia rejoiced. Venezuela was keenly taking a note of the developments. OPEC nations like Saudi Arab and Qatar had gleefully been filling their reserves with foreign riches. Developing nations like India and China though had a tough time as most of their oil needs get imported.

Fig 1 (Source: vox.com)

However from June 2014 the oil prices took a hit. They tumbled down and have reached a low of $60 by mid-December. This has been a result of various factors. High prices spurred the countries like United States and Canada to look out for oil reserves and exploit them. In their quest of oil they found two oil rich reserves- North Dakota’s shale formation and Alberta’s oil sands. These have been sources difficult to extract in the past but with better technology are now accessible. Hence there has been a boom in tight oil. US has added 4 million new barrels of crude oil per day in global market since 2008.

Fig 2 (Source:vox.com)

The other factor which accounts for low oil prices has been decline in the demand of oil in places like Europe, Asia and US. US began tapering off thanks to weakening economy and new efficiency measures after recession. China and many nations of Europe like Greece, Germany and Spain have been fighting their own recession and economic downturn. Indonesia and Iran too have been cutting back on fuel subsidies. On the other hand, by mid 2014 political disruptions which had created a furore in oil prices started lasing off. Libya came out of its Civil War. Two of its oil exports terminals- Es Sider and Ras Lanuf became functional again. Iraq too stabilized.

These factors lead to an increased production of oil in the market. The OPEC nations which enjoy larger monopoly over oil production and prices were taken aback by the situation. When the OPEC nations met in November it was expected that on account of increased production of oil in the market and their decreasing prices they would cut down on the production of oil and thus balance the demand to supply there by leading to a rise in the prices. On the contrary Saudi Arab took a stand not to cut down its supply. They came with a statement by Abdulla El-Badri, Secretary General, OPEC. who declared that “We will produce 30 million barrel a day for next 6 months and we will watch how the market reacts.” The statement inferred that Saudi Arab wasn’t willing to risk what it did in 1980’s when a similar situation demanded them to cut down oil production. Saudi Arab , then, cut down its oil production along with other OPEC nations which significantly eroded their market shares. Saudi Arab, hence very well, meant that it wasn’t ready to risk its market share again. The oil prices plummeted further. It tumbled down to $8o in mid November and then to $60 in mid December. Saudi Arabia expected that low prices would throttle the US oil boom and they would eventually get out of business. They on the other hand would be able to survive this scare on account of their huge foreign account surplus of $750 billion. However oil prices went for a free fall.

Now the issue which confronts is that would this free falling oil price likely to stay or shall redeem its value back?

Statistics suggest that at $60 per barrel some US companies would cancel or scale back shale drilling since a number of companies are already pulling out of Texas Permian Basin for now. Others though shall cut out their costs and keep drilling. In this aspect its important to state that different nations of the world have different break even price for oil production. While for Russia its $101, Iraq has it at $126 and Iran has it at $133. Thus these countries at a price of $60 are facing huge losses. At this price its estimated that Russia’s growth will be highly hampered. There have already been reports of unrest and political instability in Russia and Venezuela on account of such low oil prices.

Hence though history suggests that oil prices shall rise again but it shall be subject to different constraints. An unstable Libya or Iran shall lead to further imbalances in the price. Oil prices shall also be a subject to the performance of the economies of nations like China and India which are major importers. A Europe turnaround out of its malaise shall also affect the prices. Even an OPEC cut down of oil production would empirically affect the oil prices. These incident would lead to a significant demand in oil and hence would lead to an increase in the prices. Though one or a combination of these factors swaying away shall have opposite affects.

Fig 3 (Source: vox.com)

However the timing of the prices going up again is still a question to think over. The shale boom in US isn’t likely to pull back until oil gets so cheap that people cant make money drilling it. The breakeven price of different companies and nations very much depends upon how good they are and where they are drilling. Oil fields too wont get dry sooner. For a change stronger drilling companies might replace weaker ones but the production of shale oil would be there to stay for a while. The low prices though seem to be a boon to the oil importing advanced economies of the world like China and India.

Hence oil break phenomenon is a result of a number of factors. These factors when alighned together lead to this free fall. Though the prices are expected to rise again on the basic principle of demand and supply but its difficult to predict the correct timing of the same.

This article has been authored by Md Arbab Zafar Danish from NMIMS Bangalore 


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2. http://www.wealthdaily.com/articles/why-oil-and-gas-will-rise-again/5408

3. https://www.straight.com/news/753106/gwynne-dyer-how-far-will-oil-prices-collapse-and-how-long

4. http://www.telegraph.co.uk/finance/oilprices/11283875/Bank-of-America-sees-50-oil-as-Opec-dies.html

5. http://us.beyondbullsandbears.com/2014/12/15/lower-oil-prices-stay/

6. http://www.houstonchronicle.com/business/article/Cheaper-oil-doesn-t-mean-a-plastics-price-break-5951732.php#/0

7. http://www.fool.com/investing/general/2014/12/16/what-oil-price-would-break-linn-energy-llc.aspx

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