Oil Price Dive: Explanations Beyond Supply and Demand

Produced and published by Global Gold.

The oil price is considered a benchmark that affects the global energy market, which represents about 7% of world GDP. It is also a determinant factor affecting other commodity markets that have experienced a correlated drop, ever since oil entered its downward spiral. To understand the true scale of the situation we are in today, we refer to oil expert and author of “The Trace of Oil”, Bertram Brökelmann: As he explains, the daily world consumption of oil is about 90 million barrels. At an oil price of USD100 per barrel, USD3.3 trillion flow from the wallets of oil consumers to the pockets of oil producers. Should the oil price sink to USD30 per barrel, the cash flow will fall to USD1.1 trillion. This is the magnitude of the hit taken by oil producing countries these past couple of years, with their budgets and investment plans being thrown off course by oil price fluctuations. In this article, we look beyond mere supply and demand, to identify the underlying causes of the oil price dive.

Mainstream arguments

“The world is drowning in oil”, a statement from the International Energy Agency read this past January, and indeed, ever since June 2014, the oil price has seen a nosedive from USD115 per barrel to today´s price of USD50, after hitting a 13-year low of below USD35 earlier this year. This has had a serious impact on the global economy and still is a major concern. The mainstream argument attributes the price drop to oversupply in the oil market as a result of higher output from the US shale oil industry. Thanks to the technology of oil fracking, America’s oil production has exceeded that of the world’s largest oil producer, Saudi Arabia (responsible for 13% of total world oil production) in 2015.

Another often cited reason for oil´s performance is the slowdown in the Chinese economy, and the resulting reduction in Chinese demand for oil. However, according to Ruchir Sharma, head of emerging markets at Morgan Stanley Investment Management, the timing of the oil price plunge has even more to do with the Federal Reserve’s quantitative easing (QE) program: “Easy money had kept oil prices artificially high for much longer than fundamentals warranted, and as Chinese demand and oil supply had started to turn back in 2011, oil prices have now merely returned to their long-term average”. In other words, the bubble that was only growing bigger with QE, ultimately had to burst.

To examine this perspective, we take a closer look at the relevant announcements made by the Fed. In June 2014, the Federal Open Market Committee made another USD10 billion cut from its quantitative easing program, bringing the Fed’s monthly bond purchases to USD35 billion. The Committee’s statements also reflected an optimistic tone: “The Committee currently judges that there is sufficient underlying strength in the broader economy to support ongoing improvement in labor market conditions.” The Fed certainly adopted a positive outlook towards the economy, and in turn the market was convinced that tapering would continue. The oil price began to drop steadily in June, and continued to do so after the Fed officially suspended the six-year long QE program in October.

Why hasn’t OPEC done anything?

OPEC is the key player in the world oil market with its members producing around 40% of the world’s crude oil and Saudi Arabia being the largest contributor. Russia, although not an OPEC member, produced 10.85 mb/d in 2015, which represents around 11% of world oil production, competing closely with Saudi Arabia’s market share.

As a result of the prolonged downtrend of oil prices, OPEC’s earnings dropped by 14% in 2014 from 2013 levels, while over a third of this revenue is generated by Saudi Arabia alone. It might, therefore, seem odd at first that OPEC has not adjusted its supply levels to offset the price drop, but we ought to consider the political motives and the interests of its member states in preserving their market shares, particularly Saudi Arabia’s strategic objectives. After all, OPEC countries, especially those in the Middle East, enjoy rather low production costs compared to others and are therefore in a better position to absorb the shock from low oil prices (even though it does have an impact on their state investment plans).

Conflicting political agendas behind cheap oil

We may not forget that OPEC is an international organization consisting of member states – and so it is not and cannot be politically neutral, unbiased or independent. In April, oil producers met in Doha, to discuss production quotas, but failed to reach an agreement. Iran was absent from the talks, and it is worth mentioning that the country aims to increase production to its pre-sanction levels of 4 million barrels a day. An agreement came close to being reached, after intensive talks between Russian and Saudi parties, both of which were insistent on maintaining production levels to preserve their market share. But for the Saudis, there could simply be no deal without Iran.

The oil price downtrend has caused turmoil in the Russian economy, which was already pressured by international sanctions following the Crimea crisis. In 2015, the economy contracted by 3.5%, with expectations that the recession would continue for another year. The Russian Central Bank estimated in a “stress” test in November that with Ural crude oil prices below USD 40 per barrel between 2016 and 2018, the economy would contract by 5% in 2016. Moreover, Russian Finance Minister Anton Siluanov said in a television interview earlier this year that at these oil price levels, Russia would risk a RUB 1.5 trillion (approximately USD38.6 billion) budget deficit. Even though Russia firmly resisted cutting output in the past, it is willing to do so now if it would help oil prices to pick up.

Spill-over effects

Budgets and spending plans of oil producing states have been disrupted by the oil price dive and it remains uncertain when the market will fully recover and stabilize. Thus, an extended period of low oil prices will not only affect the socio-economic stability of oil producing countries, but it may trickle down to their regional non-oil producing partners, who already have considerably lower per capita income levels, high unemployment rates and who greatly rely on the financial support packages and investments by their Gulf neighbors.

In the absence of external financial support, the socio-economic conditions in these regions would deteriorate further and encourage more immigration to Europe, at a time when the continent is already facing its most severe refugee crisis since WWII, as described in the press. Conflicts caused by war, terrorism, oppression, and poverty have displaced over 4 million refugees, mainly coming from Syria, Afghanistan, and Iraq among others. Shifts in European public opinion and limited resources to accommodate further immigration waves, pose a serious political threat for Europe, and also raise serious security concerns.

Short- and long-term fixes

Brökelmann argues that the oil price dive is a direct outcome of OPEC’s failure to govern the oil markets, since this price does not reflect the changed realities of the market and its players. The shortcoming of the current OPEC price is that it covered only around 40% of the world market supply. However, if the United States, Russia and other oil-producing countries, such as the UK and Norway, were to join OPEC, it would have a world market share of over 70%. Accordingly, Brökelmann suggests an alteration to OPEC membership, which has remained the same since 1965, to accommodate a wider producer base; only then will the agreed upon oil price and production quotas be binding and thus more reliable.

Meanwhile, Dr. Daniele Ganser, historian and founder of the Swiss Institute for Peace and Energy Research, tackles the oil crisis from a different angle. Ganser argues that the danger of the oil crisis lies in the increasing dependence on oil. The IEA stated in its published World Economic Outlook that in 2006, the world has reached “peak oil” or the point in time when we reach the maximum rate of oil extraction, after which it is expected to enter terminal decline. As we have seen in the recent past, conflicts and economic turmoil are direct results of an oil crisis and they will only escalate with declining extraction rates. Ganser therefore argues that the only long term solution is renewable energy, and a reduced dependency on oil.

What comes next?

There is great ambiguity in the predictions for the oil market this year. After two years of oversupply, global oil production will further increase in 1H2016 after factoring in Iran – the IEA has expressed concerns that Iran’s production and export levels increased faster than expected. So far, market conditions are relatively unchanged. The dip in the oil price has severely strained political relations between Gulf players and the US, who had been investing in the shale oil industry. But now, as the shale oil industry is incurring losses, the tables seem to have turned in favor of the oil producers. As commodities expert and President of the Gold Standard Institute, Thomas Bachheimer explained, the Saudis have reached a dangerous goal: By extending the phase of artificially low oil prices, they managed to destroy any small disturbance in the supply chain, which can therefore lead to major distortions. The question is how this will affect the geopolitics of the region in the future.

 

As written for and published by Global Gold, June, 2016.

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