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Oil: A Geopolitical Conundrum

|Includes: RUSL, Direxion Daily Russia Bear 3x Shares ETF (RUSS)

Oil: A Geopolitical Conundrum

Arguably the biggest business headline during the past few months has been the sharp decline in oil prices worldwide. Since the middle of June, Brent crude oil has fallen from a peak of $115 a barrel to under $50. And it doesn't look like it's going to get any better, with Goldman Sachs claiming oil needs to hit a $40 low in order for market equilibrium to be reached.

So what exactly has caused such a big drop in oil prices? American shale oil, Saudi resistance to forfeiting market share, a decrease in consumption by the slowing down of the Chinese economy, as well as the economic stagnation in Europe, are arguably the largest factors in the recent decline of oil prices worldwide. What comes as a gain to consumers, and large consuming countries such as Japan and India, comes as a loss to producers, such as Russia and Venezuela.

The United States have recently taken over Saudi Arabia as the world's largest oil producer. American shale oil only accounted for 0.5% of the global output in oil in 2008, but has now shot up to 3.7% of global oil production. This rise in production has been good news for North Dakota and Texas, with workers flocking to shale sites such as the Bakken formation and Eagle Ford, and in general for America, which has seen its economy strengthen recently. Despite its environmental concerns- oil and gas are extracted from deep rocks underground by wrecking them with a mix of water, chemicals and sand, a process called fracking, which was recently banned by the state of New York- the shale oil industry is taking off in a large way. However, the recent drop in oil prices has hampered the growth of the industry.

Estimates places operating costs of current shale oil production at $10-$20 per barrel, while new production sites require a $70 break-even price. Output at a site tends to decrease by 60-70% after the first year of operation, and eventually dies out within a few years.

This inertia by American oil production has caused the Organization of the Petroleum Exporting Countries (OPEC) to not budge, stating that they will not intervene and reduce production. So far they have not shown any indication of changing their policy, and it is slowly starting to hurt non-OPEC members; a January 2015 report by the International Energy Agency (NASDAQ:IEA) cut the expected increase in oil supply by non-OPEC members by 350,000 barrels per day (bpd).

Saudi Arabia, the world's largest oil exporter and OPEC's largest member, does not want to give up its market share for a number of reasons. For starters, they have savings worth $900 billion that they can tap into during this time of lower prices. They have experimented with a reduction in oil production before in the 1980s, only to witness higher global prices and investment in other nations and a loss of market share. They can handle low prices easily, considering their production costs of between $5 to $6 per barrel, the lowest in the world.

In addition to not losing market share, the Saudis prefer lower oil prices for the time being due to geopolitical reasons. The American shale oil boom has made America less dependent on Saudi oil, which worries the Saudis. Also, through the trouble in Syria and Iraq, America and Saudi Arabia's arch nemesis Iran, are tacitly working together to defeat the Islamic State of Iraq and Syria (ISIS). Low oil prices may force America to reduce oil production and start importing more Saudi oil, and at the same time, it will hurt an already ailing Iranian economy. Digging deeper, oil prices are also hurting Russia, who in conjunction with Iran, are firm backers of Syrian President Bashar al-Assad, who is strongly loathed by Saudi Arabia.

Besides production by Saudi Arabia and America, there is an increase in oil production in countries such as Iraq, who saw 35-year highs in oil production this past December, further boosting OPEC output and offsetting the reduction in oil by Libya due to civil war. Combine this with the Chinese economic slowdown, European economic stagnation and new environmental ventures - President Xi Jinping of China announcing a climate change and clean energy co-operation with President Barack Obama and Germany shifting attention to renewable sources of energy- and you get a reduced demand mixed with oversupply, naturally leading to a fall in oil prices.

This price drop has profound effects across the globe. Another major headline in 2014 revolved around Russian occupation of Eastern Ukraine, and the ensuing economic sanctions. The oil drop is in itself an economic sanction, probably a reason why America and Saudi Arabia have let it fall. Russia is the world's third largest oil producer, and 68% of Russian exports are oil and natural gas. As such, oil prices play a significant role in the formation of Russia's national budget, which was calculated based on oil prices of around $100. With prices well below $100 and continuing to drop, forecasts predict a contraction of Russian GDP by 3% to 5%. Further adding to Russia's woes has been the sharp decline in the Rouble, Russia's currency. The drop in the Rouble has caused inflation to surpass 10%, reducing real incomes. The increase in interest rates to 17% has not convinced Russians to trust in the Rouble, further troubling the currency.

Direxion Russia Bull and Bear 3x Shares RUSL and RUSS have sharply changed since June, when oil prices first started to decline. These ETFs achieve results based on 300% of the performance of the Market Vectors Russia Index, which represents companies listed on Russian stock exchanges, with energy claiming 42.36% of the index weight. The Bull ETF, RUSL, has dropped significantly, from prices as high as $131 in June to around $18 today. Meanwhile, RUSS has increased from around $10 in June to over $20 currently.

Nigeria is Africa's largest oil producer, and is heavily reliant on oil, which makes up more than 90% of Nigerian exports. Nigeria requires roughly $20-$40 per barrel to maintain their fields; a drop below these prices will hurt their economic growth, possibly resulting in a bad spell in growth for the entire continent. The Naira has fallen sharply as a result of the oil prices, which was previously seen in 1998-1999, when the Naira fell roughly 80% due to declining oil prices. Presently, there has also been a drop in the Nigerian Stock Exchange All Share Index; there will be more uncertainty and likely drops in the index due to looming presidential elections and the ongoing Islamist uprising in the north east of the country.

Venezuela, sitting on the world's largest oil reserves, is facing an unhappy population, rising crime and increasing inflation. Ever dependent on oil exports, the decline in prices only adds to their gloomy future. President Nicolas Maduro recently toured Russia and Asia in order to gain backing for an increase in oil price, which did not come to fruition; in fact, oil continued to drop during his tour. A drop below $30 would likely further devalue the Venezuelan Bolivar, and likely further reduce their highly generous oil exporting program to poorer Caribbean and Central American nations known as PetroCaribe. PetroCaribe has cost Venezuela roughly $2.3 billion per year between 2011 and 2013, money that Venezuela can ill afford to lose when they are on the verge of defaulting.

Despite these setbacks, the low oil prices will surely help countries such as Japan and India who do not produce much of their own energy. Japan is dependent on oil imports, especially after the tsunami and earthquake of 2011 devastated their nuclear power plants. While currently facing dire economic conditions, the drop in oil prices acts as a boon to the economy and the weakening Yen. Japan imports roughly ¥25 trillion ($212.5 billion) of oil per year; the fall in oil prices saves Japan roughly ¥4 trillion ($34 billion). This comes as a huge cost saving to the business sector, specifically manufacturing, as it uses about 80% of the energy consumed in Japan. While initially the decline in oil prices may depress prices which is the opposite of President Shinzo Abe's goal of stopping deflation, in the long run, higher wages earned will push up the prices. President Abe is determined to keep oil prices down and the supply stable for the time being; he recently pledged $2.5 billion in aid to the Middle East in the fight against terrorism.