Understanding the oil crash

The great oil bust of 2014 is something to behold.

Since mid-June, crude prices have dropped roughly 40 percent, from $115 a barrel for the Brent benchmark to about $70 a barrel now. US gasoline prices have fallen almost a dollar a gallon, from $3.63 in June to $2.74 in early December. These declines signal a massive transfer of wealth from producers to consumers estimated at about $1.5 trillion annually by economist Edward Yardeni. Although the full implications are hazy — in part because it’s unclear where prices will settle — likely effects include a boost to the sluggish global economic recovery and political strains for some major exporters, including Nigeria, Venezuela, Russia and Iran.

 

Why is this happening? What does it mean?

Here’s what we know.

 

(BEG ITAL)The law of supply and demand did it.(END ITAL) The price collapse mainly reflects too much supply chasing too little demand. Most analysts have focused on surging US production of “shale” oil, which has increased by 3.5 million barrels a day (mbd) since 2008, according to the consultancy IHS. But the US expansion was widely anticipated, says economist Larry Goldstein. The real surprise, he argues, was lower-than-expected global demand. In early 2014, forecasters predicted demand growth of 1.3 mbd, says Goldstein. Actual growth is about half that, 700,000 mbd, reflecting unpredicted economic weakness in Europe, Japan and China.

(BEG ITAL)The small shift in the supply-demand balance resulted in significant price changes, because oil demand is “price inelastic.”(END ITAL) Modest surpluses and shortages can trigger dizzying price swings, because consumers’ needs — in the short run — are rigid. Shortages cause a scramble for supply; surpluses produce price plunges to clear the market. As it is, global oil consumption today is about 92 mbd and available production capacity is about 95 mbd, says Goldstein.

(BEG ITAL)Lower prices, if maintained, represent a huge consumer windfall.(END ITAL) All countries that are net oil importers (most of Europe, Japan, China) should benefit, but the United States — given its driving and flying habits — should be an especially big winner. If crude prices decline an average of $25 a barrel, typical households could save $500 over the next year, says economist Mark Zandi of Moody’s Analytics. On the assumption that two-thirds of the windfall is spent, the economy would grow nearly 0.4 percent faster (that’s about $70 billion in a $17 trillion economy) and generate 350,000 jobs.

(BEG ITAL)Cutbacks in oil exploration and development shouldn’t offset most of this stimulus.(END ITAL) In theory, low prices could cause oil companies to scrap new projects because they’ve become unprofitable. This would dilute the effect of higher consumer spending. But for US shale oil, the threat is modest, argued Daniel Yergin of IHS in The Wall Street Journal. He cited an IHS study, based on individual well data, finding that 80 percent of projects planned for 2015 are profitable with oil prices between $50 and $69 a barrel. (IHS assumes prices will stabilize at $77 a barrel.) Longer-term, low prices would threaten costly deepwater and Arctic projects, Yergin said. But the effect would be gradual.

(BEG ITAL)OPEC (the Organization of the Petroleum Exporting Countries) is not a working cartel.(END ITAL) Cartels prop up prices by limiting supplies. If OPEC’s members — representing a third of global oil output — were a genuine cartel, they would have prevented the price collapse. OPEC didn’t because, says Goldstein, almost all its members want “to produce every barrel they can.” Only Saudi Arabia, its largest member, would trim production to raise prices. It refused to shoulder single-handedly the costs of being a cartel.

We don’t yet know how far prices may sink or when they might rise. For many producing nations, oil revenues constitute a sizable share of government budgets. Will the squeeze cause social strife or political instability? Will it spur some (Vladimir Putin?) to become more bellicose to distract from a faltering economy? Will the damage cause OPEC members to behave like a real cartel? The oil crash is a big story in 2014. It might be even bigger in 2015.

Washington Post