Why Are Oil Prices Dropping? – A Simple Explanation

For those who watch Bloomberg or who regularly read the financial market news, it may seem a little late for someone to be writing a simple explanation of the reasons behind the recent drop in the price of oil. While spending some time with friends yesterday though, the subject of the oil price drop came up in conversation and it didn’t seem that anyone actually knew what was causing it. With this in mind I thought it would be worth posting a brief explanation of the plummeting oil price today for those who would like to know just what has caused the oil price to more than halve over the past 6 months. As with most price fluctuations it simply comes down to 2 factors, supply and demand. Let’s take them one at a time.

Supply-Side Factors

Within the space of a couple of years it seems that we have gone from worrying about the lack of available oil in the world and the implications of living in a world where oil has run out, to now worrying about the massive over supply of oil that is currently in the market. All of this has been caused by the Shale Oil Revolution in the US – otherwise known as fracking if you live here in the UK. The US Shale Oil Revolution has made a huge amount of previously inaccessible oil suddenly accessible to producers. As investors realised that there were profits to be made by taking this oil out of the ground, more and more oil started to be produced and this oil has recently found its way into the market. This huge increase in the supply of oil within such a short period of time has resulted in supply outstripping current demand. Industry analysts say that there is a current over-supply of around 2 million barrels of oil being produced each day. If there is more oil available to buy than there are people willing to buy it then that can only lead to one thing, a drop in the price of oil.

There is another side to this drop which we need to mention though, and that is the actions of OPEC – a group of some of the biggest oil producing nations in the world including Saudi Arabia, who many people think have the most say in the actions of the cartel. Usually, in situations where an over-supply of oil is evident, OPEC would step in and work together to reduce the amount of oil being produced and being sent out into the market, therefore driving the price back up. So why hasn’t OPEC cut supply this time around? Basically, it’s because they are trying to cut the supply of oil by instead forcing these newer US shale oil producers out of business, thereby maintaining their own monopoly in the oil market. Shale oil production is very profitable when the oil price is high and it is estimated that most US shale oil producers break even at between $35-$80 per barrel of oil. If oil drops below that price however then they will effectively be operating at a loss and if this were to continue for a substantial period of time then they would eventually have no choice but to stop production and go out of business. This could also make investors fearful of investing in future shale projects if they feel that they might actually lose money out of it.

Aren’t the Saudi’s losing money too though? Well the truth here is that they are and they aren’t. Although this article from The Economist states that it only costs Saudi Arabia around $5-$6 a barrel to get its oil out of the ground, it is estimated that Saudi Arabia needs oil to be at around $106 per barrel in order for the nation to be able to balance its budget. Saudi Arabia does however have $800+ billion dollars in cash reserves which they can dip into in order to wait for the US shale producers to go out of business, at which time they would hope that the oil price should rise again with less oil being produced.

Note: The following Bloomberg video on the subject of the so-called ‘New Oil Order’ shows that US shale production may be more adaptable to price fluctuations than OPEC hopes.

Demand-Side Factors

When I say that oil prices “should” rise again, I do so because there is also another factor which is weighing on the current oil price and that is a lack of certainty about anticipated demand in the coming years.

Recent data out of China and Europe has shown a slowdown in economic activity. This may be temporary or it could be a precursor to a more long term slowdown, which would inevitably drag down the demand for oil in these huge economic areas. With all of the supply-side issues we have just discussed, it does make it difficult to judge just how much of the recent drop in the oil price is down to a perceived lack of demand and how much is due to over-supply issues.

There is other data we can look at to try and figure out how much of the recent oil price drop is related to demand-side issues though. We could look to the recent slide in other commodity prices like copper for example. If commodities continue to fall even though there hasn’t been a drastic increase in their short term supply, then this might indicate that demand-side factors are actually playing quite a large part in oil’s recent drop.

Either way, oil’s recent price plummet has been quite staggering and with Saudi Arabia and OPEC seeming quite content to let it stay that way for the time being, the price may stay at these low levels for some time yet.

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2 Responses to Why Are Oil Prices Dropping? – A Simple Explanation

  1. Kathy says:

    Excellent article. Too many people in the U.S. have no concept of the global implications of the oil prices. The fact that the middle east is so adamant about driving the shale oil drillers out of business is sound evidence as to the success these companies have had in making the U.S. independent of the OPEC cartel. We need to sell as much of that oil as we need cheaply in the states and then export the remainder for as high a price as we can get. Wind and solar energy, while nice in some areas of the country, do not have the capability of making the states independent and breaking the backs of the middle east oil producing countries.

    • Adam Buller says:

      Great points Kathy. It does make you wonder what the implications might be for these middle east nations if oil were to stay between the $35 and $80 range for the long term if they rely on it being up around the $100 dollar mark.

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