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Fall in Oil Prices

11 October 2015 |

After half a decade of stability, the price of oil has fallen from around $115 a barrel to $46 a barrel in the last two years. Oil is the energy of our time. It drives factories so they can produce goods, fuels all transportation from buses to aeroplanes, and even powers refrigerators needed to store essentials such as food and vaccines. Without oil, our world might just stop turning. So why has its price fallen so, and what impact will it have?

What affects market prices?

Oil is a commodity, meaning a raw material which is homogeneous all over the world, such as gold or corn. The price of any commodity depends on three things (broadly speaking); demand for the product, the supply of it, and speculation. If demand for oil increases, its price will tend to increase with it. Picture an auction. The more people willing to pay for a product, the higher the seller will raise the price to whittle away potential buyers, until he finds one to trade with. If supply increases, the price will tend to decrease. The more units a seller has, the lower the price needs to be to encourage enough buyers to purchase the amount up for sale. Anything can impact demand and supply, from turbulent weather to war. Speculation is a little trickier. Picture an auction, but this time for a house. If people think the house will increase in value over time, the seller will raise the price because he knows people are willing to pay more for a good investment. Note that it is the belief that the value will increase over time - a speculation on how things will unfold, rather than any real matter of fact - that causes the price to change.

What caused the decline in oil prices?

Weak economic growth has contributed somewhat to the fall in price, as stagnating businesses reign in their demand for it. However, the most salient cause by far is the increase in supply of oil. Traditionally, the industry was composed of a few large oil companies and state-owned enterprises, which conducted the vast majority of the oil business. This is because the cost of equipment and platforms, developing technology, and winning state-backing was extremely high, making it difficult for competitors to enter the market. However, this all changed with the introduction of fracking, particularly in the US. Entrepreneurial shale companies, such as in Texas and North Dakota, have been able to produce shale oil cheaply and quickly. Over 20,000 new oil wells have been dug since 2010. The result is a dramatic increase in the supply of oil. The US's oil output rose from 0.5% of global oil output to 3.7% from 2007 to 2014; and shale investment projects in the US accounted for 20% of global investment in oil production in 2013. These figures reflect the sudden growth in shale companies producing oil.

Is the price fall good or bad?

For some, the fall in price is a good thing. It will mean countries that import large amounts of oil, such as Japan and India, will be able to afford even more. That will translate into lower petrol prices for their citizens, who will hopefully spend what they have saved in the economy. Businesses will also benefit from the lower prices. They could use the cheaper oil to run more factories, make transportation more efficient, and generally expand business. Both will translate into more economic activity and a boost in GDP.

For others, the fall in price is damaging. In addition to the oil companies receiving less income, countries that export lots of oil, such as Iran, Norway and Russia, will receive far less revenue too. To accommodate the reduction in revenues, these countries will have to tighten their belts. This could mean cutting spending, resulting in job losses; fewer investment projects, resulting in economic stagnation; and possibly defaulting on debts, resulting in huge liabilities.

Will the market 'react'?

Demand for supply may organically resume as the Chinese economy picks up pace and other emerging markets begin to invest in all the things that inevitably require oil. However, it is possible for oil exporters to decisively restore the price by cutting supply, so why haven't they?

OPEC, the Organisation of the Petroleum Exporting Countries, is an intergovernmental group composed of 12 oil exporters, including Iran, Venezuela, and Saudi Arabia (the world's biggest exporter, followed closely by Russia who is not party to the organisation). Given OPEC's market share of around 40%, a decision to cut supply would certainly push the price up. However, Saudi Arabia had other plans, which steered OPEC's decision to remain passive. Unlike many of the other oil exporters in the world, Saudi Arabia can afford to let prices fall because of its sizeable cash reserve of $900 billion, which will cushion the blow of any lost profits.

Why might Saudi Arabia want to let prices fall, potentially eating into its cash reserve?

First, allowing prices to continue falling will likely push the competitive shale companies out of business. These companies have little to no savings, with investments that far exceed their revenues. As the price falls and their revenues decrease, they are likely to reach bankruptcy faster than conventional oil companies. This is due in part to their comparatively small size, but also in part to the nature of their operation. Shale wells exhaust extremely quickly, with roughly 60%-70% of the oil being extracted within the first year. As a result, the fracking companies rely on a perpetual flow of investment in new wells to survive, largely funded by debt from issuing bonds (a bond is like a loan to the company for which they pay interest to the bond-holder). The decline in oil prices will cause investment to dry up as revenues fall, and given how quickly shale oil depletes in any given well, production will follow suit fairly swiftly. Failing shale companies may also spoil the fracking industry's reputation, shunning future investors who are critical to their operation - if oil prices continue to fall, the gap in funding required for the shale market to continue business could reach $70 billion a year.

In fact, to buttress the case for OPEC remaining passive, pushing oil prices back up might only incentivise potential shale companies to enter the market, or for existing ones to invest further, given the increase in income potential. Finally, Russia, who is arguably Saudi Arabia's biggest oil competitor, will be wounded by the falling prices because they do not have the financial cushion Saudi Arabia has. In fact, the drop in the oil price has already sparked concerns in Russia as the country's GDP contracted by 4.6% in the last year.

What does the future look like?

Despite this short-term hardship felt amongst the shale companies, the shale industry will probably grow in the long-term. There are fracking opportunities all over the world, from China to Eastern Europe, and finite resources dictate that they will be exploited (barring the possibility of intervention from state legislatures, due to the environmental issues fracking entails and the polemic that brings). Its advent is recent, and with time it will only grow more efficient - already for instance, between 2013 and 2014, the cost of production for shale companies fell from $70 a barrel to $57 a barrel. Mettle is often tested best in adversity, and it is likely that the weight of the fall in prices will force shale companies to innovate in order to stay alive. This will engender better technology, better efficiency, and ultimately industry growth.

In the meantime, the vagaries of the world will no doubt fluctuate the market for oil. Growth in China is likely to resume pace, Iran's nuclear deal with the US will lift economic sanctions releasing a wave of oil exportation, enduring turmoil in the Middle East may eventually crack into its demand for the commodity, and Putin's tarrying despotism might finally be challenged in an overdue socio-political uproar. If anything is more telling, the price of 'futures' for 2016 (contracts which fix the price of oil for producers to sell at a later date, in this case next year) has fallen to around $50 a barrel, suggesting that investors believe the price of oil will remain very low for the foreseeable future.