Dropping Oil Prices

The price of a barrel of oil is currently trading below $36. How can the law of supply and demand explain a 70% drop in the price of crude oil since August 2014? I realize there is a global economic slowdown, but more cars are being sold every day, especially in China.

Can the combination of an economic slowdown, along with additional supplies from North America, explain this decrease in price, or is something else going on here?

It’s a global price war,, with the Saudis leading the charge. The law of supply-and-demand explains this because there has been a ridiculous increase in supply. IOW, it’s a buyer’s market for oil right now.

[li]Crude oil glut.[/li][li]China’s economy tanking, and the coming world recession.[/li][li]Saudia Arabia overpumping to deliberately drive the price down, increase market share, and drive USA-based oil shale into bankruptcy.[/li][li]Baltic Dry Index bad.[/li][/ul]

This isn’t market forces. It’s politics on a grand scale.

I disagree. This is market forces acting on the oil market for the first time in a long time. Enough oil is being produced by sources that aren’t a part of the OPEC cartel that OPEC was no longer able to keep prices high by restricting production. In a more competitive market, the only rational thing for lower-cost oil producers like OPEC to do is produce oil as long as the price is above their cost of production.

Now, in the long-term, the low prices might drive enough non-OPEC producers out of business that the cartel regains the ability to influence the price of oil higher. That is certainly their hope, but I’m not convinced that shale oil hasn’t permanently changed the dynamics of the market.

Consensus is that it has. OPEC can drive a lot out of the market with oil at $35. But apparently they will all bounce back (whether owned by the current owners or by whoever takes it over in BK or otherwise) once prices rise. So it could get tough for OPEC in any event.

In the long-long run, it might not be the shale producers who lose out. Because shale is relatively flexible low cost in start-up. But the bigger arctic and offshore drillers require more lead time and upfront investment. The lack of investment now with oil at $35-$40 could manifest itself years down the road, with shale having recovered but Russia and others slower to ramp back up.

Even supply and demand economics don’t normally account for irrational players in the market. At current prices, OPEC is losing money. They can probably last about 3+ years continuing to produce at a loss at this rate.

That’s a misconception.

OPEC (not all, but most, especially the ME producers, e.g. SA) is making profit on their oil at these prices. They’re not making enough money on their oil for the government to balance their budget.

That’s very different than the higher cost oil producers, who are losing money on the oil itself.

The problem with viewing it as all political is that private oil companies don’t really look much beyond their own bottom line in the same way that state oil companies can. It’s a bit of a “tragedy of the commons” situation in that it’s in the interest of the oil industry as a whole to limit production to keep prices reasonable, but it’s in the individual companies’ interests to produce as much as possible while prices are high.

I think at the most basic, what happened was the US and Canadian private oil producers kept bringing on more and more production trying to maximize their own profits, figuring that as supply rose OPEC (or at least someone other than themselves) would cut production to keep prices stable. The whole narrative of OPEC intentionally trying to sink US producers I think is a little misleading since it’s not like OPEC has actually done much of anything. It’s just that those domestic producers brought on tons and tons of new capacity assuming OPEC would be willing to trade market share for price, but it turns out they’re not. At least not yet. Hence the oil glut and the low prices.

Thanks everyone. Ignorance fought.

I see in today’s paper that Russia "is drawing up plans based on a price band fluctuating between $40 to $60 as far out as 2022, a scenario that would have devastating implications for Opec."

There is always incentive to cheat in opec. Almost nobody stays below their quota, and saudi has always been known as the kingpin. If iran produces too much above their quota, saudi isnt afraid to boost production and make irans oil less valuable.
Ive also felt the oil market is only partially based on metrics, but also on fear and trends. When oil is making a run, it keeps going, we saw this when it was $147 a barrel a few years back, which I felt was way over market value. Now its the opposite. No worries, with all the instability in the middle east, oil will reverse its trend and climb back up.

My understanding is that the US and (especially) the Canadian oil fields are not profitable at the current prices. The problem is that oil fields cost a lot of up-front time and money to set up. Canada and the US had a lot of fields being developed, and once the field is nearly online they lose less money by finishing it and selling the oil then stopping and getting nothing for the capital that they’ve already spent (in economic terms, current prices are above their variable costs, so it makes sense to continue pumping, but it doesn’t cover their fixed costs).

The current situation may well lead to bankruptcies by North American oil firms (not the giants like Exon-Mobil, but the smaller regional players). A lot of them issued debt to finance construction and were expecting revenues from higher oil prices to allow them to pay off the debt. They also have scaled way back on starting new projects, because they won’t be profitable. In the long run, this should clear the supply glut and get prices back to a more normal level. However, this won’t happen until exiting wells start drying up.

What happens next is anybody’s guess. OPEC would love to go back to restricting supply, jacking the price of oil way up and making huge profits. As Fotheringay-Phipps alluded to above, this may not be possible. One of the very interesting aspects of shale oil is that it’s much cheaper (on an absolute scale, not on a per barrel of oil scale) and faster to start production than traditional wells. The trade-off is that one shale oil project doesn’t produce as much oil. Many people believe that if OPEC tries to restrict oil production again, that will raise the price of oil back to the point where shale oil is profitable, and then the shale oil producers start up again and we go through another price crash. Maybe potential US oil producers won’t because they’ll be afraid of being slapped down by OPEC again. It’s hard to be sure.

It’s a mix of politics on a grand scale and market forces. Saudi’s in a turf war with Iran in several countries in the ME, proxy wars with Iran and Russia, and financial war with North American producers. It has actually increased production to over 10 million bpd recently.

Also fracking is taking place in many countries, demand is increasing but not as fast as supply, and alternatives are now serious contenders for a large portion of domestic energy in many countries. The recent high prices - over $100 - were an anomaly which allowed for massive investment in developing new sources of oil and natural gas, and in developing alternatives.

I expect the current low prices to continue as Russia has stated and for longer than most people expect. Most countries’ oil companies are committed to paying their workers and shareholders so cannot reduce production, and the government-owned oil companies (mostly in the Gulf) are paying for their citizens’ welfare and so also cannot reduce production. It’s going to take something very large to reduce production, and so hike the price, before it’s due.

Setting aside all the politics, there’s another issue for the OP.

Saying “supply and demand” is using high school-level economics. Reality, even absent the special features of the oil industry, is vastly more complex.

One of the biggest issues is something called “elasticity.” How much less do you drive when gas is up 50 cents/gallon? Probably approximately zero. How much more do you drive when gas is down 50 cents/gallon? Probably approximately zero.

The vast majority of energy consumption is baked in. Actual consumption doesn’t, and in many cases, *can’t *change when the price changes.

The result of that is when a shortage occurs, prices explode because people will pay whatever it takes to meet the 99% of their consumption that is fixed. And when a glut occurs, producers have to slash prices to stimulate any meaningful amount of demand for what’s wholly optional consumption.

Over longer terms, like months and years, both consumers and producers can react to persistent price signals by altering behavior. Sell the Hummer & get a Prius. Sell the Prius and get a Hummer. Move closer to work. Move out to the country. Insulate the house. Drill more oil wells. Build or shutter a refinery.

All of those are lumpy decisions that take time and dollars to implement. Meanwhile the price of oil is jittering madly up and down because of elasticity. So correctly teasing out the long-term motion to guide your investment decisions (Prius or Hummer?) is very difficult. Which leads to most producers’ and consumers’ actual actions lagging the price signal that’s visible only in hindsight.

Which lag in turn amplifies the elasticity-driven short term spikes & crashes.

Another point to make - Saudis traditionally adjusted their supply down if others cheated in OPEC in order to keep the total supply, and hence price, up. This time they have declined to do so, for various reasons mentioned above - to stick it to their regional rival Iran who needs the money more than the Saudis; to stick it to their ally America’s rival Russia, who is being a difficult force in the world in general, and seems to be Iran’s buddy at the moment.

Another factor commentators have mentioned - in previous downturns, when the Saudis reduced production, their customers went elsewhere; when they resumed full production, it was harder to get those customers back. This time, they’ve decided to keep their customers.

I would argue that the demand is more inelastic for lower price than higher price. If gas is $1.00/gal, you are not going to drive 3 times as much. But, if gas were $8/gal, you’d sure as heck drive as little as you could get away with. Similarly, prices for industry and transport skyrocket and there’s less economic activity, some plants close because they can’t sell their widgets at the higher price, etc.

So yes, the current crop of fracking wells need to be exhausted, and then there will be an episode of higher prices which will cause the less expensive fracking wells to be developed or re-open until they are exhausted, and so on. So, we’re in for a decade or five of lower prices until the source of cheap fracking oil is fairly well exhausted.

what hasn’t been mentioned is the devastation wrought upon marginal, high-cost oil producers…like Brazil. Petrobras is in the midst of a huge scandal-the senior executives stole over $5 billion from the company. meanwhile, they lose $30/barrel on every barrel they pump (their oil is all from deep offshore wells). Or Venezuela 9they have no market for their heavy crude)-they just had a reversal in national elections-I expect the country to enter a state of instability which could result in a revolution. The effects are being felt ij Cuba, as Venezuela was bankrolling the (bankrupt) Castro regime.
So many effects, and not all of them good.

The hope here, of course, is that these unprofitable producers will scale back, reducing the supply and keeping the price from dropping more. But… some producers (Venezuela?) fall in the category of desperate, or pay their workers in local and sell in hard currency, so need to keep pumping like crazy. One flaw in the Venezuela system IIRC is a lack of real exchange rates.