Oil Prices: Whats Behind the

Plunge? Simple Economics

By CLIFFORD KRAUSS UPDATED September 1, 2015 RELATED ARTICLE
Photo

States like Texas will face economic challenges from the drop in oil
prices. CreditMichael Stravato for The New York Times
The oil industry, with its history of booms and busts, is in a new downturn.
Earnings are down for companies that have made record profits in recent years,
forcing them to decommission more than half their rigs and sharply cut investments
in exploration and production. More than 100,000 oil workers have lost their jobs,
and manufacturing of drilling and production equipment has fallen sharply.
The cause is the plunging price of a barrel of oil, which has been cut roughly in half
since June 2014, reaching levels last seen during the depths of the 2009 recession.
Prices recovered a bit in the spring, but have fallen again in recent weeks. Executives
think it will be years before oil returns to $90 or $100 a barrel, pretty much the norm
over the last decade.
Continue reading the main story

1.

Whats the current price of oil?

Brent crude, the main international benchmark, was trading around $48 a barrel
on Monday.
The American benchmark was at around $45 a barrel.

2.

Why has the price of oil been dropping so fast? Why

now?
This a complicated question, but it boils down to the simple economics of supply and
demand.
United States domestic production has nearly doubled over the last six years,
pushing out oil imports that need to find another home. Saudi, Nigerian and Algerian
oil that once was sold in the United States is suddenly competing for Asian markets,
and the producers are forced to drop prices. Canadian and Iraqi oil production and
exports are rising year after year. Even the Russians, with all their economic
problems, manage to keep pumping.
On the demand side, the economies of Europe and developing countries are
weakening and vehicles are becoming more energy-efficient. So demand for fuel is
lagging a bit. China's recent devaluation of its currency suggests the economy of the
world's biggest oil importer may be worse off than expected.

3.

Who benefits from the price drop?

Any motorist can tell you that gasoline prices have dropped more than a dollar a
gallon. Diesel, heating oil and natural gas prices have also fallen sharply. Households
are likely to spend $750 less on gas this year because of the oil prices, the United
States Energy Information Administration said in January. Europeans and
consumers around the world will enjoy similar benefits.
The latest drop in energy prices regular gas nationally now averages around $2.65
a gallon, compared with $3.45 a year ago is also disproportionately helping lowerincome groups, because fuel costs eat up a larger share of their more limited
earnings.
Gasoline prices are inching up as refineries do maintenance to switch to more
expensive spring and summer gasoline blends.
As the price of crude oil fluctuates, why some countries are faring much better than
others.

4.

Who loses?
For starters, oil-producing countries and states. Venezuela, Iran, Nigeria, Ecuador,
Brazil and Russia are just a few petrostates that will suffer economic and perhaps
even political turbulence. Persian Gulf states are likely to invest less money around
the world, and they may cut aid to countries like Egypt.
In the United States, Alaska, North Dakota, Texas, Oklahoma and Louisiana will face
economic challenges.
Chevron and Royal Dutch Shell recently announced cuts to their payrolls to save
cash, and they are in far better shape than many smaller independent oil and gas
producers that are slashing dividends and selling assets as they report net losses.
Some smaller oil companies that are heavily in debt may go out of business,
pressuring some banks that lend to them.

5.

What happened to OPEC?

A central factor in the sharp price drops, analysts say, is the continuing unwillingness
of OPEC, a cartel of oil producers, to intervene to stabilize markets that are widely

viewed as oversupplied. Prices of OPECs benchmark crude oil have fallen about 50
percent since the organization declined to cut production at a 2014 meeting in
Vienna.
Iran, Venezuela and Algeria have been pressing the cartel to cut production to firm
up prices, but Saudi Arabia, the United Arab Emirates and other gulf allies are
refusing to do so. At the same time, Iraq is actually pumping more.
Saudi officials have said that if they cut production and prices go up, they will lose
market share and merely benefit their competitors. They say they are willing to see
oil prices go much lower, but some oil analysts think they are merely bluffing.
The death of King Abdullah in January has prompted speculation that Saudi Arabia
could shift direction, and there has been some softening in the Saudi public position
in recent days. But for the immediate future, most analysts say the Saudi royal family
will resist any sharp changes in policy, especially as it tries to navigate multiple
foreign policy challenges, like the chaos in neighboring Yemen.
If prices remain low for a year or longer, the newly crowned King Salman may find it
difficult to persuade other OPEC members to keep steady against the financial
strains. The International Monetary Fund estimates that the revenues of Saudi
Arabia and its Persian Gulf allies will slip by $300 billion this year.

6.

Is there a conspiracy to bring the price of oil down?

There are a number of conspiracy theories floating around. Even some oil executives
are quietly noting that the Saudis want to hurt Russia and Iran, and so does the
United States motivation enough for the two oil-producing nations to force down
prices. Dropping oil prices in the 1980s did help bring down the Soviet Union, after
all.
But there is no evidence to support the conspiracy theories, and Saudi Arabia and the
United States rarely coordinate smoothly. And the Obama administration is hardly in
a position to coordinate the drilling of hundreds of oil companies seeking profits and
answering to their shareholders.

7.

When are oil prices likely to recover?

Not anytime soon. Oil production is still increasing in the United States and some
other countries.
Demand for fuels is recovering in some countries but production is likely to only
begin declining in the coming months. Then crude prices should also begin to recover

in a lasting way. The history of oil is of booms and busts followed by more of the
same.

The Energy Outlook; LULLED TO

SLEEP BY THE OIL GLUT
MIRAGE
By DANIEL YERGIN
Published: June 28, 1981
T HE oil crisis has given way to the oil glut. This perception is reinforced by an almost
daily litany of price reductions on the world market. Yet, the word ''glut'' is misleading,
for it suggests that the days of easy availability have returned. This is a dangerous and
potentially costly illusion, based on a misinterpretation of what is going on. What we
have is a breathing space, not deliverance.
But memories are short when it comes to energy. To quote from a newspaper article,
''There is a great deal of OPEC oil around - perhaps two million barrels a day - that
cannot find a market without discounting that undermines the price structure that the
organization was designed to defend.''
1981? No. December 1977. Indeed, through 1977 and 1978 press and public discussion, as
well as that in the oil industry, was dominated by the glut psychology.
This was followed by a two-year period, 1979-80, in which prices rose by 170 percent and
sent shock waves through the world economy. But now the glut psychology is back.
A glut implies some major collapse in oil prices, which has not happened. It would be
much more on the mark to say that there is currently a surplus in the world market - one
that could just as easily disappear in a matter of months as continue well into next year.
The spot price for oil is about where it was last September, before the Iran-Iraq war,
although very little spot crude is currently being traded. Discussions that make so much
of a drop of a few dollars in current official prices set by the Organization of Petroleum
Exporting Countries should be measured not in the abstract but against the key fact that
the price had just finished moving up $22 or so a barrel.
Moreover, many of the price reductions actually refer to the whittling back of ballooning
premiums that had been added to the basic price. Thus, what we are really seeing is a
leveling off and settling down of prices.

This relatively minor price weakness has arisen because of important changes in the
balance between supply and demand. Oil consumption in the Western world dropped
more than 7 percent between 1979 and 1980, and is expected to drop another 3 percent
in 1981. OPEC production is down almost 20 percent since 1979, to about 25 million
barrels a day.
There are a number of reasons. To begin with, the sharp increase in OPEC prices has
certainly restrained demand. It would have been truly amazing had demand not budged
at all in the face of a jump from under $13 a barrel to almost $35 a barrel. The jump was
even greater in the United States because of decontrol. Conservation is definitely at
work, proving that there is a lot of flexibility in how we use energy.
But other factors come into play. This latest bout of OPEC price increases has dealt a
punishing blow to the economies of the West. The Western world grew at just over 1
percent in 1980, compared with 3.3 percent in 1979, and this recession has been a major
contributor to lower demand. The same thing happened after the 1973 price increases,
when oil consumption in the West fell about 7 percent. There has also been a good deal
of fuel switching, especially to coal.
Finally - a point much overlooked -it appears that the inventories of oil are being run
down rapidly. Free world stocks had risen from a low of 4.3 billion barrels in early 1979
to 5.5 billon barrels by last October. Today, according to some estimates, they have
dropped about 10 percent, to about five billion barrels. Oil companies are trying to run
down their inventories because of the high interest rates. It currently costs $6 to $9 on
an annual basis to keep a barrel in stock. Moreover, final consumers, such as industrial
companies, also appear to be running down their supplies instead of buying additional
barrels.
These factors explain the changes in oil demand. Yet they are only part of the reason for
the present surplus. Remember OPEC production would be down in any case because of
the war between Iran and Iraq. The market might actually be in rough balance were it
not for a decision by Saudi Arabia to produce substantially above its 8.5 million-barrelsa-day ceiling in an effort to enforce its price views on other producers.
Saudi Arabia is hardly opposed to further increases in the real price of oil. But the Saudis
do oppose rapid leapfrogging; they want these prices to move upward in a stable pattern
in the context of a so-called ''long-term strategy.'' They rightly fear that, with recent
prices as high as $41 a barrel, and the associated momentum to push even higher, the
producers might well be in danger of providing a vast incentive for conservation and
alternatives to OPEC oil. And the Saudis have the most to lose in the long run.

The Saudis thus are using their production strength to stop temporarily the upward
move of prices, and to reunify those prices around their own marker crude. They are not
very likely to allow official prices to fall below their $32 base.
H OW long will the surplus last? There are too many uncertainties for anyone to say with
assurance. But a number of the key factors are subject to very quick turnaround. One of
the most important is when and by how much the Saudis cut back their output. The
apparent cut of 500,000 barrels a day will not do it, but a further reduction of a million
barrels a day or so would pretty quickly erase the surplus and rather instantly end the
glut psychology. If there is progress on reunification of price, it's likely to be matched by
further Saudi cutbacks.

Much also depends on the rate at which Iranian and Iraqi crude petroleum returns to the
market, which in turn will be affected by two big imponderables - the extent of damage
to their oil facilities and the level of hostilities between the two nations. Equally large
questions hang over oil consumption. Demand for oil will be lower if economic recovery
in the United States is postponed, or if the downturn in Europe is prolonged, or if
developing countries cannot afford to buy oil.
Demand will also be very much affected by the tempo of energy efficiency. The leveling of
oil prices, the perception of a glut, the cutback in the United States of programs to
accelerate efficiency, and the loss of interest in the whole problem, as happened in '77
and '78, could all undercut efforts to become more energy efficient and develop
alternatives. Already, there are indications that driving might be 20 percent higher this
summer.
In other words, the surplus could continue well into 1982, or could disappear by this
winter. It is generally thought now that economic growth in the West this year will be 1
percent, or less. But consider what happens if the Western world experiences a more
rapid economic recovery before the end of the year. Then, oil demand will go up. This,
combined with normal stockbuilding in the autumn, could put a lot of pressure on the oil
market, pushing prices higher. Tightness in the market could be accentuated by the
current running-down of inventories by oil companies and final consumers, which could
mean that oil inventories could be much lower by the autumn - making demand even
higher.
Hanging perpetually over everything else is the ever-present ''X'' factor -the revolution,
the coup, the war, the freak event that interrupts supply -and higher prices. After all, in
1979, a shortage of perhaps less than 5 percent created panic conditions.

Oil from Alaska, the North Sea and Mexico have been very important additions to the
world oil market, but there are no major new sources likely to come on stream in the
next few years. Meanwhile, many OPEC producers have become more interested in
restricting production to keep prices up, and it is widely expected that United States
domestic production will continue to decline, although at a slower rate because of
decontrol.
Important progress has been recorded in the oil consumption of the Western world. But
it is much too soon for complacency and selfcongratulation. The supply system remains
fragile and crisis-prone - making the Western world vulnerable to further oil shocks, and
devastating price increases in the years ahead. The one constant is uncertainty. What is
truly striking as a measure of dependence on OPEC is that demand could fall so far and
so fast with such minor impact on price.
But why the return of the glut psychology? Glut is an attractive idea. It makes many
people feel more secure, and after two years of anxiety about oil, it's a great relief to
believe the problem is over. But it isn't.
--------------------------------------------------------------------- Daniel Yergin is co-author of
Energy Future: Report of the Energy Project at the Harvard Business School, and is a
member of Harvard's Energy and Environmental Policy Center.
Illustrations: graph of O.E.C.D. oil consumption from 1972 to 1980 graph of OPEC
output from 1972 to 1980 graph of official cartel crude price from 1972 to June of 1981