The dummy’s guide to the recent crash in oil prices.

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Black gold isn’t so valuable these days. Current estimates at the time of writing show WTI crude oil selling for $56 dollars p/barrel and Brent crude oil selling for $61 dollars p/barrel, the lowest prices since May 2009. In this blogpost, I discuss what events caused the price to plummet, as well as who feels the consequences.

Why has the price of oil fallen?

Western and developed nations didn’t need so much…

  • Japan, having closed its nuclear programme and temporarily switched back to oil due to the Fukushima disaster, has reinstated its nuclear plants and no longer needs so much oil. This took a customer off the market.
  • Germany, France, and China had all increased their industrial sectors, and needed more oil to feed them. But the post-recession expansionism in their respective economies has steadily dissipated. This again takes some customers off the market because their economic recoveries have lost their edge.
  • The U.S., responding to the then-high price of oil, dramatically stepped up hydraulic fracturing, or fracking, a dangerous and inefficient process which tarnishes the environment and uses enormous amounts of water in order to squeeze oil and gas out of the Earth. As damaging as it may be, it’s become more popular than sliced bread and is sweeping across the continental United States. As a result, the U.S. has halved the amount of oil it imports, down to 30% from 60% in 2005, and is now producing 2442 thousand barrels per day more than it was in 2008. Again, another customer off the market.

Meanwhile, oil exporters continued to pump out more oil…

  • Iran, languishing under Western economic sanctions imposed on it for pursuing a nuclear weapons programme, desperately stepped up oil production in an effort to save its economy from ruin. This poured a lot of oil into the market.
  • Iraq, the world’s fourth-largest oil exporter, was increasingly under threat of hostile takeover by the militant group ISIS, who panicked the world when it was announced they’d overtaken some refineries (the panic proved to be out of proportion). This panic always affects the markets involved, and drove the price of oil up as investors and governments feared a huge exporter was about to be wiped off the map. The failure of ISIS to seize all of Iraq’s oil meant the country’s oil production remained steady. Again, this poured a lot of oil into the market.
  • Libya, temporarily disrupted by the fall of Muammar Gaddafi, is now back on its feet in terms of oil production, and is desperate to undo the damage left by the regime change by selling off as much oil as it possibly can. That’s another nation pouring more oil into the market.
  • The U.S., having boosted its hydraulic fracturing industry, has also poured more oil into the market.

So this is something of a classic case of supply outgrowing demand: The oil producing nations have increased their output (or kept it going, in the case of Iraq) and saturated the market, while nations that were hungry for extra oil are all back to normal appetite levels (with the exception of the US., which is a lot less hungry).

What does this mean for countries that deal heavily in oil?

It’s not great news. Some countries heavily rely on oil revenues to keep their books balanced. Think back to the Scottish referendum, when Alex Salmond promised that austerity measures would be unnecessary in an independent Scotland, thanks to the presence of black gold in the North Sea. Drink up all the oil, sell it off, and fund public services. A simple method, provided prices remain high. But if Scotland had voted yes and Salmond finalized his budget on the back of oil production, the current price dip may have proved extremely uncomfortable for his government.

In the non-hypothetical world, using oil revenues to fund your public services is always a risky business, but times get especially tough when something causes prices to fall. For example, the IMF estimates that Iran needs the price of oil to be at least $131 per barrel to avoid having a budgetary deficit, meaning that at current prices, its government needs to find approximately an extra $75 for each barrel they sell to keep the books balanced. Indeed, Nigeria, an OPEC member, has already revised its national budget to account for the low oil prices, while any impending spending cuts or price rises by oil-exporting Venezuela could trigger a repeat of the deadly riots that occurred in 1989.

As you can see in the chart below, Iran, Venezuela, and Nigeria are just three countries among many that rely on oil revenues to provide basic services. For Russia, the world’s second-largest oil exporter, the news could be especially dire given that the troubles in Crimea are landing them with economic sanctions, while the falling rate of their currency (the rouble) is making tech firms and other businesses very nervous.

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It would be unwise to think Saudi Arabia increasing their oil output is a mistake or a strategic blunder. The country has huge saving reserves and continues to be rich no matter what the cost of oil. It appears willing to be patient during what it sees as temporary dips in prices while the fracking craze burns itself out and the U.S. returns to the market with its tail between its legs. After all, there is huge internal opposition to the process of fracking, with NIMBY groups sprouting up all over the states, and with New York becoming the first state to place an outright ban on the practice.

One thing is clear: The Saudis have no intention of intervening where the price of oil is concerned, and it seems to be a deliberate attempt on their part to drive their old foe Iran’s economy into the ground, a tactic they’ve employed in the past. As OPEC’s most influential member, Saudi Arabia has often come to the rescue in the past, reducing oil production and imposing a minimum price to return prices to normal. But this time they’re doing no such thing, and are actively driving prices down by pumping as much oil as they can, up to 11.8 million barrels a day from a previous 8 million. Iran is attempting to get OPEC to bring prices back up to normal levels (which it collectively has the power to do), but the Saudis are blocking their efforts, something the Iranians consider a “treacherous … conspiracy against the interests of the region”.

In short, Saudis seem content to ride out the storm and wait for their old foe, Iran, to experience an economic crash. They seem to think themselves invulnerable. In their eyes, it’s not like any developed nation is getting off oil and replacing it with renewables any time soon, and they most likely subscribe to the “peak oil” theory, which proposes that oil will only become more valuable over time, due to the fact that it’s a finite resource and is running out. Economics 101: The less of something there is, the more valuable it is.

One thing is for sure: The Saudis don’t have much choice but to keep selling oil. Their economy has failed to provide any other lucrative industry, in part because one wasn’t needed, thanks to the seemingly never-ending supply of black gold.

Time will tell if Saudi Arabia’s theories prove correct, but two threats will present themselves:

  • In the short run, the U.S. shale gas (fracking) industry may not decline, and may become an integral part of the oil industry, seriously undermining the Saudi’s political muscle in OPEC.
  • In the long run, the increasingly cheap price of renewables like solar, coupled with imminent disaster if climate change is not curtailed, means the Saudis may find themselves being one of the last bastions of oil in a world that no longer needs it. By 2050, a mere 36 years, oil is expected to have dried up completely (notwithstanding any new major discoveries).

Will anybody else feel the effects of these low prices?

Yes. Not everybody has financial reserves and fancy theories in order to wade out storms like these. For private businesses, the lack of profit that inevitably comes from low oil prices is a direct threat to their company.

The UK is the most prominent example of how low prices can damage exporting industries. Britain is not a huge player in the oil market, and like with many of the nations in the chart above, needs prices to remain high in order to make a profit; $60 p/barrel in this case.

Companies like Premier Oil and ConocoPhillips are having to make enormous cuts in order to save their businesses, which as usual, translates to job losses (some 230 in the case of CP).

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