Oil Price Decline Stems From Classic Supply-Demand Imbalance

by: 679-research

Summary

Sluggish economies in Western Europe and a slowdown in China’s economic growth rate account for the bulk of the drop in demand on a global basis.

The US is now the world’s largest oil producing country, surpassing the previous leaders in oil production, Russia and Saudi Arabia.

The recent sharp decline in oil prices reflects a combination of factors that have resulted in a classic situation right out of basic economic theory: supply and demand.

By Lew Koflowitz

Crude oil supply continues to increase sharply, particularly in the US - the result of the shale revolution that has enabled US production to rise dramatically over the past several years.

Saudi Arabia has maintained its high level of crude production despite falling demand, although in August it exported less to global markets than in July. Meanwhile, Russia's output has continued to rise to near-post-Soviet record highs.

The combination of shrunken demand and rising supply has resulted in significantly lower oil prices around the world. As of noon Eastern US time on October 24, the benchmark Brent crude was at $86.48 a barrel for December delivery. That was down about 20% from a peak in the summer.

In turn, gasoline prices have plummeted in recent months. A report in Forbes.com on October 22 put the average gas price at $3.14 a gallon across the US, citing gasbuddy.com. - down about 50 cents or about 15% since July. In some places, prices are well below $3.00. The Forbes report said the price in Missouri, at $2.77, was the lowest in the country.

The sharp gasoline price drop provides additional support for the US economy, by freeing up cash that consumers can use to purchase other goods and services.

Background

The US has been experiencing a sustained boom in oil production, driven by big boosts in "fracking" (hydraulic fracturing) and horizontal drilling. We're now producing about 8.7 million barrels of crude a day, the highest level in decades, according to CBSNewsInteractive.

Indeed, the energy boom in the US is estimated to have created more than 100,000 jobs in the oil and gas extraction industry from 2008 through 2013, according to an October 21 article on FoxNews.com, thus making a significant positive contribution to the US economic recovery.

Further, the US now imports much less oil than it did in past decades, which is contributing to a relative glut in the rest of the world. Libya and Iraq are ramping up production as well. At the same time, a weak economic recovery -- or perhaps even a return to recession -- in Europe and slowing growth in China are restraining global demand.

The Impact of Lower Prices

Lower crude and gasoline prices are expected to pay off big time for the US economy. In addition to freeing up consumers' wallets to purchase other goods and services, the lower oil costs are likely to contribute to reduced transportation costs for the shipment of goods and services, as well as reducing operating costs for airlines, in both cases helping to improve their bottom lines.

While lower oil prices are expected to be a positive for the US economy going forward, certain sectors are expected to experience a negative impact. For example, major energy stock prices have already fallen. Furthermore, while there is currently plenty of oil production, if as expected, prices continue to fall, it will be become uneconomic for many US producers to maintain their production levels. An analysis by Goldman Sachs indicates that US producers would stop earning a profit if the price of crude drops below $85 a barrel. Other analysts put that number at $80 a barrel.

"Some U.S. producers will start to reconsider new drilling if prices fall below $85, especially ones that are highly indebted, unhedged or are drilling in relatively costly areas," said Robert McNally, president of The Rapidan Group, an international energy consulting firm based in Bethesda, MD. "However, most U.S. production would likely continue unless prices fell into the $70 range, in which case many more companies would reconsider continued drilling," putting the US oil boom in jeopardy.

In other countries, falling oil prices have already begun to take their toll. For example, in Russia, which has already been weakened by sanctions imposed by the US and Europe over the crisis in Ukraine, the government has based its draft budget for 2015 on an assumed oil price of around $100 barrel. In Iran, which is also heavily reliant on oil sales, and whose economy has already been weakened, will be harder hit as the price of crude continues to decline. Venezuela, another big oil-producing country, is also suffering from declining crude prices.

Will OPEC Survive?

There has been much speculation about whether the OPEC oil cartel is dead, or nearly so, and whether it can ever again exert any significant pressure on members to reduce production and thus stabilize oil prices.

The US oil and gas boom is "breaking the back of OPEC," according to the FoxNews.com analysis. In addition to the growth of US production, Saudi Arabia continues to send large amounts of oil into the global marketplace - and with overall demand down, the price continues to drop precipitously.

"You can't have a cartel if the world's largest producer -- America -- isn't a member," the article concludes. "OPEC will never again be able to hold the world at knife's point and create the level of economic turmoil that the Arab members of OPEC engineered in the 1970s with their oil embargo." It added that the "shale energy boom is no short-term fad. It could make energy cheaper for decades to come."

The Bottom Line

The energy boom in the US has generated a positive catalyst for the US economy overall. While the stock market continues to see volatility, the longer-term impact of continued lower oil prices on both the economy and markets is likely to be positive, in terms of both domestic and export activity. If prices fall sufficiently so that energy companies cannot make a profit, they will reduce their levels of exploration and production. Meanwhile, lower oil and gas prices are a plus for the US.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.