Oil prices: What is behind the drop? Simple economics

09:29 PM @ Wednesday - 14 January, 2015
The oil industry, with its history of booms and busts, appears to be in the early stages of its latest downturn. The price of oil has plunged more than 55 per cent to under $50 a barrel since June. That is the lowest price since the depths of the 2009 recession. Oil analysts predict that the price could fall below $40 before beginning to rebound. But even optimists say $70 a barrel by the end of the year is highly doubtful.

Why is the price of oil dropping so fast? Why now?

This a complicated question, but it boils down to the simple economics of supply and demand.

US 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 found a home in the US is suddenly competing for Asian markets, and the producers are forced to drop prices.

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.

Who benefits from the price drop?

Any motorist can tell you gasoline prices have dropped more than a dollar a gallon in recent months. Diesel, heating oil and natural gas prices have also fallen sharply. All together, they represent the equivalent of a sizeable tax cut — putting $1,000 or more in the pockets of the average family over the next year. Europeans and consumers around the world will enjoy similar benefits.

Who loses?

For starters, oil-producing countries and states. Venezuela, Iran, Nigeria, Ecuador, Brazil and Russia are just a few petrostates that will suffer economic and perhaps even political turbulence. Persian Gulf states are likely to invest less money around the world, and may cut aid to countries like Egypt.

In the United States, Alaska, North Dakota, Texas, Oklahoma and Louisiana will face economic challenges. Some smaller oil companies that are heavily in debt may go out of business, pressuring some banks that lend to them.

What happened to Opec?

The price of oil, as with other commodities, goes up and down. And in the past the Organization of the Petroleum Exporting Countries, known as Opec, has frequently cut production to firm up prices. Iran, Venezuela and Algeria are pressing the cartel to do so again, but Saudi Arabia, the United Arab Emirates and other gulf allies are refusing to cut. At the same time, Iraq is actually pumping more.

Saudi officials have said that if they cut production and prices go up, they will lose market share and merely benefit their competitors.

They say they are willing to see oil prices go much lower, but some oil analysts think they are merely bluffing.

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 still increasing in the US and some other countries. Many Wall Street banks are predicting that the oil price could fall as low as $40 a barrel in the coming months. But production is likely to begin declining in the second half of the year, and then crude prices will also begin to recover. The history of oil is a history of booms and busts followed by more of the same.
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