Oil's Plight
'...when we take a look behind the facade of the markets...the picture of supply and demand become far more complex'
Jack Curliss | 6 March 2016

Market turbulence, rising debt and another possible financial crisis… why? Oil. This precious liquid is a high-demand global commodity, responsible for the tax revenues of governments, profits of producers and disposable incomes of consumers the world over. A fall in oil prices used to be considered relieving for the economy, now markets are not so sure.

 

The value of a barrel of oil has dropped by around 60% in just over a year, sending oil dependent countries, such as Nigeria and Venezuela, running to the world bank for billion dollar bailouts or throwing them into political chaos. For such major impacts it seems hard to believe that the price is determined by just two primary factors: supply and demand. If demand increases or supply decreases, we would expect the price of oil to go up. Likewise, if demand decreases or supply increases the price should go down. Yet, despite their supposed simplicity, when we take a look behind the façade of the markets and see what factors really underlie them, the picture of supply and demand becomes far more complex.

 

 

 

 

 

 

Full throttle…

 

United States domestic production has nearly doubled over the last several years. The main reason for this has been combinations of new technology, such as fracking, that unlocked oil previously unavailable to drillers. However, this forms only a small proportion of the 90 million barrels per day (b/d) of worldwide production, and hence forms only a fraction of our story.

 

As US production increased, the need by Americans to import oil fell, which forced Algerian, Saudi and Nigerian oil, once sold in the United States, to now compete among Asian markets. Strong competition between these oil giants has consequently forced producers to drop prices.

 

What occurred in the recent past has also had an effect. Previously, high oil prices caused confidence to boom, which encouraged investment into the exploration of new oil sites. This was at a time when worries of running wells dry plagued investors’ minds. Now their efforts have done the exact opposite; this push towards preventing shortages has thrown world supply into a glut. In an attempt to whittle down their own mass reserves, countries have refused to import oil – excess supply which consequently has needed to find another home.

 

However, arguably the most prominent supply side factor in all of this mayhem came from the world’s largest cartel. OPEC’s (Organization of Petroleum Exporting Countries) decision not to force countries to cut oil production has increased the downwards pressure on prices. The main reason for their decision was Saudi Arabia. The Saudis blocked calls from poorer countries in the organisation to decrease production, by using their market power. They were allowed, and wanted, to block this move being the second biggest supplier of oil in the world, producing around 12-13% of the total daily output. Being the second largest producer, Saudi Arabia wanted to preserve its market share - a cut in production would threaten that, a risk which they were clearly not willing to take.

 

In the future, production is most likely to fall. A drop in exploration investments, transpiring from low profits, and a cull of the costliest producers, should aid this. RBC Capital Markets has found that many projects, capable of producing more than 500,000 b/d, were cancelled, delayed or shelved by OPEC countries last year and 2016 promises more of the same.

 

The other side of the story…

 

Whilst the supply of crude oil has dramatically increased, falls in demand have been the main concern underlying the huge drop in prices. Growth in European economies and developing countries has been weakening, which contributed largely to decrease demand.

 

Most importantly, however, has been the last several years of booming economic growth in China finally slowing down. Whilst China’s economy is still growing at around 7% - near astronomical growth compared to that of the UK – the growth rate has fallen considerably in recent years.  The devaluation of the Chinese currency also suggests that its economy may be worse off than expected. As China is the biggest importer of crude oil in the world, slowdown has inevitably led to a decrease in demand and therefore the price of oil as well.

 

As technology and vehicles become more environmentally friendly and energy efficient, demand for oil will continue to fall. Until then, oil exporting countries can only hope for a change in global conditions, ushering in a period of economic and political stability, to ease the pain on their balance sheets. 

 

Image issued under Creative Commons license

James Routledge 2016