The falling price of oil

The fall in oil prices is not new. Since its peak in June (over $100) the price of oil has been decreasing. Prices dropped to $40 recently.

This is the lowest price level since the failure of Lehman Brothers in 2008. I must confess that I delayed writing on the subject, but it is time to discuss this unexpected event that has interesting consequences since the reasons behind the price tumble are more clear now. The main reason, as is the case in all price changes, is the disequilibrium between supply and demand. Supply increased while demand remained sluggish. But why?

The demand side is easier to explain. The European economy is still in trouble and in China economic growth has stalled. This is enough to create weak oil demand in the global market.

On the supply side the reality is more complex. First, OPEC, the trust of oil exporting countries that has a one-third share in the in global oil market, is producing more than planned. Some OPEC members such as Nigeria and Venezuela asked Saudi Arabia to reduce its production, but the biggest exporter and the cheapest producer has decided to maintain its production level. The reasons for this firmness are not very clear, but it does not seem to have something to do with a so-called secret understanding with United States that aims to bring Russia to its knees. On the contrary, some experts think that Saudi Arabia is annoyed by the development of the United States' production through the exploitation of bituminous schists. Indeed, the United States increased its oil production by 15 percent in 2014, stopped importing and started exports.

Russia and Iraq, two important exporters, also pushed up their production. According to French daily Le Monde, Russia reached the peak in December, a level that has been not seen since the 1991 fall of the Soviet Union. Iraq has also broken a record in exports (3 million barrel / day) recently.

Obviously there is more oil in the market than needed. The second issue is the future of oil prices. Will prices be dragged below $50 or will they start to increase? Many experts think that prices will be dragged down this year. I learned recently that Iran set oil prices at $40 when preparing its 2015 budget. I learned also that wells discovered in recent years are ready for production this year and next year. This information indicates that oil prices will continue to remain at a very low level.

However, there are also some aspects that should be taken into consideration concerning the future of oil prices. First, things could start moving on the demand side. A revival in Chinese growth is possible if the American revival persists, and Europe may find a way to grow if measures currently being undertaken end up being efficient. If these two events happen, oil demand will be more robust.

Second, on the supply side, it is likely that production will start to decline. A number of wells discovered in past years have quite high production costs because of their geographical placement: in the depths of the ocean or in Siberia. For short-run oil prices, supply is closely dependent on marginal production cost, excluding investment cost. In a recent paper, Michael Lynch, a petroleum economics analyst, suggests $80 as the marginal cost of oil production. This means that a market price below this price will cause the most costly drills to shut down. Frankly, I do not know what equilibrium price would equalize supply and demand. But it would probably around $70 for the short run, say within a year.

Personally, I do not believe that oil prices will be maintained at very low level. An increase is unavoidable but prices will certainly not exceed $100. But in the long run, say within two to three years, since investment to discover new fields will decline and --hopefully -- an economic revival will occur in the European Union and United States, oil prices might increase up to $100. So, all economic measures considered as a consequence of cheap oil must be decided very carefully.