Econometrics Project

Recent Slump in oil Prices

By: Arun Goyal2k11/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.

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.

Role Of OPEC

At its big meeting in Vienna on November 27, there was 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, OPEC is 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 killUS Oil Industry

Analysts often focus on a metric called the "breakeven price" for oil-drilling 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.