December‘s $54 price for a barrel of crude oil is a far cry from the $105 mark we saw only six months ago. That is around 48% decrease in oil prices which is driving the Russian and Venezuelan economies to the ground as they highly depend on oil with Russia set to lose £51bn in oil revenue.
Why the sudden drop?
Oil reached dizzying heights in July 2008 when crude prices soared to $148 per barrel which was due to increasing demand for oil which supply couldn’t keep up with. Those impressive numbers attracted new competition for the already established oil producers; in the US, shale extraction saw crude production increase by four million barrels a day.
Recently, however, oil demand has stumbled as Japan‘s economy enters a recession, China‘s growth slows, and the West turns to alternative energy sources. With shale production continuing to increase and the increasing oil production from Libya and Iraq production, the market found itself to be oversupplied which drove the price down.
How will it stop?
It was hoped that OPEC would agree to reduce production, but in their November meeting it was clear that was not going to happen. Saudi Arabia (OPEC’s most influential member) tried to maintain its market share by weathering the storm. Even though 90% of Saudi’s exports consist of oil products, it has one of the largest forex reserves and sovereign wealth funds which should help cover its expected budget deficit. The Saudi Oil Minister has been relatively quiet in the past few months but last week he stated that Saudi Arabia is ready to increase its oil production. It seems Saudi still remember the glut it experienced when it reduced production in the 1980s.
It is also important to note that if OPEC does decide to reduce production, other non- OPEC members will fill the supply gap, especially with news that Kurdistan could increase production by 400,000 barrels a day. Saudi Arabia might also have geopolitical reasons for maintaining a low oil price; the effects of which are providing difficulties for the Russian and Iranian economies, which are considered foes to Saudi and its ally, the United States.
In terms of shale production in the US, it is quickly becoming unattractive to investors due to its high cost of production. Reports have stated that the break-even price is around $80 per barrel for some companies. As it is an infant industry, most production companies are likely to have borrowed in large amounts and need to make regular repayments.
When will it stop?
But what if shale companies decide to be resilient? If they decide to keep drilling, there can be some comfort and hope that the low oil prices will stimulate economic growth in the US, China, Europe and Japan which could lead to growing oil demand and higher prices in the long run. To drive the price back up, one of three things needs to happen: 1) OPEC members must decide to cut production, however this seems unlikely; 2) Shale Production must lose the price war and cut production to maintain sustainability; 3) Low oil prices could improve slowing economies and thus raise demand for oil.
It seems that Saudi is trying to drive out competition from the market, it is a risky position to take but it seems Saudi can maintain this position for at least the next year in that time some competition will be squeezed out of the market, although resilience is expected from Shale companies. So it seems prices might improve in 2016 but it seems unlikely it will reach the $100 mark before 2018. It seems things will get worse before they get better for the oil producing countries.
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