Since June 2014, the oil price has dropped by some 60 per cent: from $115 per barrel to $44. Looking at the history of oil prices over the last 30 years, this qualifies as one of few extraordinary developments. Only five times during this period did prices drop by more than 30 per cent over a six-month interval. These instances coincided with major events such as the changes in OPEC policy in 1985-86, the Asian financial crisis in 1997, the American recessions in 1990-91 and 2001 and the global economic crisis in 2008-09.
Is the absence of such immediate and obvious extreme systemic events a sign that powerbrokers in Washington and Riyadh are behind the price decline, aiming at bringing rivals to their knees? Conspiracy theorists claim that the United States want to subdue the Russians in the Ukraine crisis as well as the Iranians in nuclear negotiations, while also toppling the disdained regime in Venezuela. All three countries are particularly vulnerable due to the double effect of sanctions and the drop in oil prices.
But what would the instrument be that Washington could use to artificially lower the oil price? In the United States, the market dictates production volumes and prices. In a fragmented US market – where wells producing just a few barrels a day at costs between $20 and $50 a unit account for close to ten per cent of output – advances in technology combined with a lack of state-coordinated production led to an oversupply that ultimately hurts business. Shale extraction generally needs an oil price of $50-$70 to remain lucrative. Investments are already being stopped and expensive offshore projects are being re-evaluated. The French-American drilling company Schlumberger had to cut 9000, Haliburton 8000 jobs. The world’s largest mining company, BHP Billiton will discontinue the operation of ten of its 26 onshore shale oil rigs in the United States by June, moving quickly to respond to low oil prices and maintaining its entire activity under review. Also, incidentally, one of the winners of recent price developments is China. Why would this be a goal of the US Government?
If not the US, then maybe the Saudis are the conspirators? Why did Riyadh not throttle oil production in order to restrict supply and keep the prices balanced? The explanation of Saudi Oil Minister Al-Naimi that Riyadh was concerned with losing market share should it lower production seems reasonable. To be sure, Riyadh will not be distraught at seeing low oil prices hit American shale and offshore explorations. And yes, given its enormous currency reserves, it is much better positioned than its Iranian rival during this price crisis. Such thoughts have nothing to do with conspiracy, but a lot with competition.
The current market developments are most similar to the OPEC policy change in 1985. In a situation where only a comparatively high oil price made expensive exploration and extraction – offshore at that time – feasible, Saudi Arabia decided to protect its market share and disregard its previous role as market balancer. It thereby induced a price drop of over 60 per cent from $24 to $9 - prices remained relatively low for over a decade.
In the mid- to long-term, not even Saudis have an interest in the current situation either: they need an oil price of $106 in order to balance their budget, which is inflated by social benefits meant to appease the population in the context of the Arab Spring.
While other commodity prices have been steadily dropping since 2011, the oil price was kept close to $105 a barrel until the second half of 2014 by geopolitical concerns that for a while masked the underlying economic factors. Despite all conspiracy theories, the reasons for the drop in oil prices lie with three factors, all of which follow market rules: the interplay of supply and demand, unrealistic market expectations and the appreciation of the US Dollar.
Firstly, the rising global oil supply is essential, particularly due to American shale exploitation. The increase of US production alone over the last six years surpasses the output of each of the OPEC members with the exception of Saudi Arabia. US Shale production expanded in particular in the $80 break-even range of extraction. Last week, US oil stockpiles reached with 407 million barrels an 80-year high. At the same time, the Saudi Kingdom, that in the past has acted as a buffer, varying its immense production capacity to stabilize the price of oil, changed its policy within the OPEC and maintained a high output in 2014. In contrast, demand for 2015 has been repeatedly corrected downwards by the International Energy Agency – in the second half of 2014 alone by 0.8 million barrels per day – due to moderate world economic growth.
Secondly, speculators also bet on a stronger growth of world economy and higher oil prices. In July 2014, there were four million long oil futures contracts. The drop in oil price led to a wave of sales and induced a domino effect. Investors also reassessed growth prospects of oil exporters – particularly outside of the Middle East – which led to a flight of capital from these countries, straining their economies. The recall of petro-dollars invested around the world in return conversely affects oil importers.
Thirdly, the announcement by the US Federal Reserve to halt quantitative easing and consider raising interest rates increased the value of the dollar by 10 per cent against currencies of major trade partners – especially with the European Central Bank pursuing a converse policy. As oil is being traded worldwide in dollars, the resulting strengthening of the American currency contributed to a falling oil price. Moreover, countries affected by a declining currency might reduce their demand for oil leading to even lower demand.
On the other hand, during the last six months of 2014, it became clear that geopolitical developments only had a very limited effect on the oil and gas supply. The activities of the Islamic State did not significantly affect oil production in Iraq, Libyan output recovered by 0.5 million barrels per day and Western sanctions on Russia did little to perturb the flow of hydrocarbons.
As macroeconomic consequences, energy intensive industries and ones using petroleum products as feedstock will benefit from lower oil prices. Income will shift from oil-exporters to oil importers, potentially expanding demand. Based on historical data, a drop of over 30 per cent between the average oil price of 2014 and 2015 would be expected to contribute 0.5 per cent to global GDP in the medium run. However, this effect will most probably be absorbed in the next two years by the suboptimal state of the world economy.
The development of oil prices over the last decades resembles a rollercoaster ride. The interaction of demand and supply, but also real and expected political crises, interruptions of exploitation, the monetary policy of central banks and speculative deals have led time and again to large up- and downward movements.
In Davos, the head of ENI, Claudio Descalzi, just announced that the oil industry would slash 10-13 per cent of its investments. Similar numbers were confirmed by Patrick Pouyanne, chief executive of Total, who already announced limiting investments in oil fields on the US East Coast as well as in the North Sea until prices rebound to at least $70 a barrel. This trend is insofar particularly concerning as solely the natural drop in yield of existing oil fields will by 2030 require substantial exploration and investments to achieve 50 million barrels of additional production a day.
BP CEO Bob Dudly might be right with his recent prognosis that oil prices will remain low for the next three years. But as low as at present? There is a lot that speaks in favour of a rebound in the foreseeable future. While 2015 might still see a production increase in the US despite a lower number of active wells, the supply will soon drop – in the medium term mainly driven by the cooling-down of the shale boom in the US, in the long term determined by these severe cutbacks in investments. The expectations of speculators will alter accordingly. Global oil demand will increase – despite the triumphal expansion of renewables due to population growth – thanks to urbanization and the emergence of a middle class with significant purchasing power on all continents. Oil remains an important energy source whose price is shaped – just as in the past – on a global market. There is little room for conspirators.
Friedbert Pflüger is Director of the European Centre for Energy and Resource Security (EUCERS) at King‘s College London and former German Deputy Minister of Defence. He is also Managing Partner of two consultancies in Berlin and Erbil.