Wednesday, 6 April 2016

Oil Prices: What’s Behind the Drop? Simple Economics

    Some 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. Credit Michael Stravato for The New York Times

The 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 over the last year, but the cost of a barrel of oil has already sunk this year to levels not seen since 2003 as an oil glut has taken hold.

Also contributing to the glut was Iran’s return to the international oil market after sanctions were lifted against the country under an international agreement with major world powers to restrict its nuclear work that took effect in January.

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  $38 a barrel on Wednesday.

The American benchmark was at around $37 a barrel.

Why has the price of oil been dropping? 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. 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.ny 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 just above $2 a gallon, roughly down about 40 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.



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.

Major producing countries will meet on April 17 in Qatar, and some analysts think a cut may be possible, especially if oil prices approach $30 a barrel again.

King Salman, who assumed power in Saudi Arabia in January 2015, may find it difficult to persuade other OPEC members to keep steady against the financial strains, even if Iran continues to increase production. 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.

Oil markets have bounced back more than 40 percent since hitting a low of $26.21 a barrel in New York in early February.

Some analysts, however, question how long the recovery can be sustained because the global oil market remains substantially oversupplied. In the United States, domestic stockpiles are at their highest level in more than 80 years, and are still growing.

But over the long term, demand for fuels is recovering in some countries, and that could help crude prices recover in the next year or two. - The New York Times

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1 comment:

  1. The Saudis are going insure that this low oil price drop lasts for quite sometime probably for several years to come. The Saudis are going to attempt to and probably bankrupt many USA shale producers and their investors. USA shale production is the threat that the Saudis are trying to contain.

    The USA shale producers rely on leverage, borrowed money from the banks, seed capital from investors and moderate to high oil prices to stay solvent.

    The Saudi induced price drop will last long enough to exhaust oil pricing hedges, last long enough to cause banks to tighten credit, last long enough to cause investors to seek greener pastures and last long enough to reverse the growth of USA shale oil production. The price drop will last until it gets these needed results. This will probably take 6 months to upwards of two years depending on the oil marketplace reaction. Most USA shale oil production is hedged 6 months out dropping steadily to very low levels after 1 year. As these hedges expire there is no place to hide for the higher cost USA shale oil producers who will scale back or shutdown operations.

    After oil prices rise again, the banks and investors will likely not fund USA shale producers again because they know if they do, the Saudis will screw them again. It is not a question of if but when.

    The Saudis can not absolutely control the long term price of oil but they can inject oil price volatility into the market which impacts the risk analysis and increases the margin of safety demanded by investors to fund new oil exploration anywhere. For instance now some oil futures contracts are selling in the $30 range which would have been unthinkable 1 year ago. This is because the implied long-term oil price volatility has increased. The Saudis are just trying to contain the growing global production of oil as best they can. This growing global production is negatively impacting future Saudi wealth.

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