How Low Can Oil Go?

Posted on December 16th, 2014 in Uncategorized by Karl
The article below argues that a 2-3% increase in supply (Libya and US shale) combined with a slowdown in the economy in the US, Europe and China is responsible for the 40% drop in oil prices in the past six months.  
The New Yorker, 12/16/2014.  By: James Surowiecki

Just in time for Christmas, there’s a surprise present for consumers: plummeting oil prices. They have fallen forty per cent since July—gasoline now costs well below three dollars a gallon—saving Americans hundreds of millions of dollars a day. This has been a mini-stimulus for the economy, and one that was almost completely unexpected. Before the summer, prices had been high for years. Despite a lot of geopolitical turmoil and macroeconomic anxiety, the oil market had been remarkably stable, and it seemed possible that, as one study put it, “hundred-dollar oil is here to stay.” But in a matter of months all that changed.

So what happened? At the most basic level, it’s a simple supply-and-demand story. Europe’s continued troubles and a slowdown in the Chinese economy muted the demand for oil. Meanwhile, the U.S. shale-oil boom and a rebound of drilling in Libya boosted supply. “Libya’s ramping up of production caught people genuinely off guard,” Steven Kopits, the managing director of Princeton Energy Advisors, told me. “That’s the kind of thing that’s hard to predict unless you have really good intelligence assets on the ground.” The result was that the market was producing many more barrels of oil a day than were consumed. As oil was dumped on the market, prices inevitably fell.

Such volatility is exactly what the history of oil prices would lead us to expect. Commodities are more volatile than other assets—the price of copper fluctuates a lot more than that of a television set—and oil has historically been more volatile than most other commodities; a 2007 study found that in the U.S. it was more volatile than ninety-five per cent of other products. The biggest reason for this volatility is that short-term supply and demand for oil are what economists call “price-inelastic,” which means that they don’t respond much when the price of oil changes. People don’t immediately start driving less when gasoline prices spike—they just pay more for gasoline. On the supply side, drilling projects take a long time to start up or to shut down, so higher prices don’t immediately translate into more supply, or lower prices into less. This means that the way prices typically return to normal—through increasing supply or diminishing demand—doesn’t really happen in the oil market. So a two- or three-per-cent change in supply, which is about how much the shale boom and the Libyan rebound added to global daily production, can spark a huge move in price.

In recent years, hedge funds and commodity-index funds have put hundreds of billions into the oil market, and studies suggest that this flood of investment may have increased the market’s volatility. By its nature, oil trading is beset by uncertainty. It’s not just the precarious geopolitics of where most of the world’s oil reserves are. There’s also the fact that predicting future demand requires forecasting the performance of the entire world economy.

You might think that the existence of OPEC would guarantee stability. But OPEC is weaker than it once was, thanks to the emergence of big non-OPEC oil producers, like the U.S. Besides, enforcing stability at a time of falling prices is easier said than done. OPEC’s members face a classic collective-action problem. They’d be better off ultimately if they all agreed to curb production—Saudi Arabia, in particular, would have to cut back—but individually they have a greater incentive to continue pumping. And the Saudis know from history that cutbacks don’t always work. In the early nineteen-eighties, they slashed output in an attempt to prop up energy prices. “They cut production and cut production and cut production, and all it did, more or less, was wreck their economy for the next twenty years,” Kopits said. “This time around, they’re drawing a line in the sand and saying We’re going to keep pumping, and everyone else is going to have to adjust around us.”

The shale-oil boom has added to uncertainty, too. OPEC has no control over what U.S. producers do. And even though shale-oil producers often face higher production costs than traditional drillers do (which should make them quick to cut production when prices fall), many also have debt payments to make and fixed costs to meet if they don’t want to go out of business. So they’re likely to keep pumping, since that keeps revenue coming in until (they hope) the price recovers. But continuing to pump, of course, makes it harder for prices to stabilize.

It would be a mistake for oil producers to expect a return to the high, stable prices of recent years. By the same token, American consumers shouldn’t get too used to cheap gas, since in the long run low oil prices erode the conditions that brought them about. Producers are already starting to adjust: ConocoPhillips just announced that it’s cutting its drilling budget. And, because cheap oil gives everyone an economic boost, eventually it leads to higher demand. We’re awash in oil right now. Soon enough, we may be wondering where it all went. ♦

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