Never say never, but unfortunately, things are not looking bright for the oil prices this year. Understanding the drop is essential to predicting future developments, and the nature of it pretty much boils down to the simple laws of supply and demand, athough the impact of a strenghtening US dollar and a reduction in investment cannot be ignored.

The price of oil fell suddenly in mid-2014, and has been nearly cut in half since June of that same year. On 7 January 2016, Brent Crude, the international benchmark, reached record lows of US$33.92. One of the most commonly accepted reason for this unwelcome change in the market is the boom in US shale oil production. The development of this particularly capital-intensive segment of the oil and gas industry was able to accelerate thanks to extraordinarily high prices, with Brent Crude peaking at US$114.81 on June 20, 2014. This rapid growth of the segment then gave shale oil enough preponderance in the market to have a significant impact on global oil prices. The unforeseen surge in supply, however, led the price to crumble down to the present figure since suppliers of oil to the US suddenly had to relocate their exports. The increase in supply is compounded by the fact that global production capacity is constantly expanding, with Canada and Iraq increasing production and exports, not to mention an expected boost in exports from Iran, a consequence of the market opening to international investors. Weak growth in the global economy added and the rise of energy efficient vehicles are stopping the market from absorbing this oversupply, forcing prices to drop further.

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Brent Crude Price Over 2011-2016. Source: Bloomberg

The role of OPEC in this situation is highly debated. While some believe the organization should regulate the price of oil by cutting back in production, others argue that this would lead to a loss in OPEC’s market share, which would conflict with the organization’s own interest.OPEC’s current strategy, according to these critics, is to bring the oil prices to a level so low that it removes all profitability from oil production, eliminating the countless small US shale oil producers. It is widely held that OPEC has been failing in its role as an oil price stabilizer over the past 18 months, as it has often acted to stabilize the market in the past by altering supply. It did so during the great recession in 2008, the Arab Spring, and the Asian financial crisis. However, these three instances have one important factor in common: they were temporary shocks. The rise of shale oil, on the other hand, represents an integral change in industry structure, rather than a short-term blip. To grasp this concept, BP’s Chief Economist makes a comparison between asking OPEC to respond to shale oil and asking the organization to respond to our entire vehicle fleet being replaced by electric cars. Nonetheless, its strategy to pump oil at all costs is leaving holes in the budgets of Saudi Arabia and its Persian Gulf allies, estimated at US$300 billion for this year.

There is some hope for a rise in oil prices in 2016, but it remains only a glimmer. Certain signs lead experts to believe that production in the US and other oil-producing countries is declining due to the drop in exploration investments. If supply does not stabilize itself, however, demand might, with demand for oil recovering in certain countries. Critics have different forecasts for the future of oil prices, one of which is that the halt in expensive projects in the Arctic waters or the Canadian Oil Sands will reduce the oversupply, but only once today’s excess inventories are burned off. This would allow prices to return to start rising continually again. Others argue that the natural flexibility of shale oil production will regulate the market and set a cap on rising prices (see article The New Economics of Oil for more on this). Although one could expect oil production to drop due to the measures implemented to combate climate change, this is relatively unlikely, with governments such as Britain, Germany, and Spain curtailing handouts for renewables.

All in all, if oil prices have proven to be one thing, it is unpredictable. For all the forecasts that were made, no one anticipated the sudden drop in price. Only time will tell if conventional oil is following in the footsteps of coal, or if it this phenomenon is just a bump in the road.

 

Source: The Wall Street Journal, NY Times, BP, oilandgasmexico.com

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