Econometrics Project

Recent Slump in oil

Prices
By: Arun Goyal
2k11/ec/035

Volatile Oil
Global oil prices have fallen sharply over
the past seven months, leading to
significant revenue shortfalls in many
energy exporting nations
From 2010 until mid-2014, world oil prices had
been fairly stable, at around $110 a barrel. But
since June prices have more than halved. Brent
crude oil has now dipped below $50 a barrel

Reason
There are three main reasons for this
change
Weak demand in many countries due
to insipid economic growth
Surging US production.

Rising US Production
When oil prices were soaring during the mid-2000s,
energy companies found it highly profitable to use
fracking, horizontal drilling, and other techniques
to extract oil from shale formations in places like
Texas and North Dakota.

 It costs more to frack oil from shale rock in North

Dakota than it does to pump out oil from conventional
fields, like those in Saudi Arabia or Kuwait. So, when
prices were plummeting last year, many onlookers
figured it would wipe out the US oil industry.
US oil drillers have certainly been affected by the
recent crash. The price of West Texas Intermediate fell
from $95 per barrel in July 2014 to less than $50 per
barrel today. The result? It's less profitable for many
companies to keep pumping for oil in difficult shale
formations the way they used to.

That dynamic can't last forever, though. Most of the oil

wells drilled in the shale regions of North Dakota and Texas
tend to produce a lot of crude very early on and then start
declining sharply within a few years.

So over time, oil producers will need to keep drilling new

wells to maintain production. But it's costly to drill a new
well, and low oil prices make this a less-attractive
proposition at the margins. Companies like EOG Resources
and Hess have already announced cuts to capital spending
this year.

Role Of OPEC
As prices slid, many observers waited to see whether OPEC, the
world's largest oil cartel, would cut back on production to push
prices back up. (Many OPEC states, like Saudi Arabia and Iran, need
higher prices to balance their budgets.) But at its big meeting last
November, OPEC did nothing. Saudi Arabia didn't want to give up
market share and refused to cut production in the hopes that
lower prices would help throttle the US shale boom. That was a
surprise. So oil went into free-fall.

At its big meeting in Vienna on November 27, therewas a lot of

heated debate among OPEC members about how best to respond to
the drop in oil prices. Some countries, like Venezuela and Iran,
wanted the cartel (mainly Saudi Arabia) to cut back on production in
order to prop up the price. These countries need high prices in order
to "break even" on their budgets and pay for all the government
spending they've racked up
On the other side of the debate was Saudi Arabia, the world's
second-largest crude oil producer, which was opposed to cutting
production and seemed willing to let prices keep dropping.

Decision Of Saudi Arabia

Officials in Saudi Arabia remember what happened in the 1980s, when

prices fell and the country tried to cut back on production to prop them
up. The result was that prices kept declining anyway and Saudi Arabia
simply lost market share.
What's more, the Saudis have signalled that they can live with lower
prices in the short term. (The government has built up $750 billion in
foreign-exchange reserves to finance deficits.)

Price War

For all intents and purposes, OPECis now engaged in a "price

war" with the US. What that means is that it's relatively cheap to
pump oil out of places like Saudi Arabia and Kuwait. But it's more
expensive to extract oil from shale formations in places like Texas
and North Dakota. So as the price of oil keeps falling, some US
producers may become unprofitable and go out of business. And
the price of oil will stabilize. At least that's what OPEC members
hope.

Will low oil prices kill

US Oil Industry
Analysts often focus on a
metric called the
"breakeven price" for oildrilling projects the
price of oil necessary for
a project to produce
reasonable returns.
ScotiaBank has estimated
breakeven prices for
various shale and oil
sands projects across
North America:

Effect Of Oil Prices

China, which is set to become the largest net importer of oil, should gain
from falling prices. However, lower oil prices won't fully offset the far
wider effects of a slowing economy.
Japan imports nearly all of the oil it uses. But lower prices are a mixed
blessing because high energy prices had helped to push inflation higher,
which has been a key part of Japanese Prime Minister Shinzo Abe's
growth strategy to combat deflation.
India imports 75% of its oil, and analysts say falling oil prices will ease
its current account deficit. At the same time, the cost of India's fuel
subsidies could fall by $2.5bn this year - but only if oil prices stay low.

Will global oil prices stay low?

This is very hard to predict. If oil demand remains

weak and production stays high, prices might not
bounce back for some time.
But the world is full of potential surprises. Conflict
could break out again in Libya or Iraq, which would
hamper oil production. China's economy could come
roaring back. Europe could suddenly rebound out of its
malaise. Saudi Arabia could decide that enough is
enough and cut back on production all of the sudden.
Any of those things could increase prices.