by Kenneth Wallace-Mueller, Member of the MEF Board
The recent sudden drop in the price of Brent crude oil came as a surprise globally and has had wide-reaching effects. Despite involving a variety of actors, the issue is effectively a simple macroeconomic disruption of supply and demand with its roots lying in geopolitical developments within the last two decades.
At the beginning of the 2000s, global oil price held steadily at about 25 USD per barrel. Primarily due to strengthening industry in China, global demand increased; however with ongoing conflict in the Middle East, oil production was reduced.
During this time, the United States had almost doubled oil production and stands to overtake Russia and Saudi Arabia to become the world’s largest oil producer in 2015. This phenomenon is supported by shale oil extraction by hydraulic fracturing, known also as fracking.
This technology allows the extraction of oil and natural gas locked in shale rock by pumping high-pressure fluid into the ground, literally fracturing the rock – a technology developed in the late 1940s, however due to its high costs it only recently became economically sustainable because of the high oil price.
This increase in US production had however little effect on the global oil price due to the reduced production in the Middle East.
With increased global oil demand, supply was slow in catching up, causing the oil price to increase further, with the oil price peaking at approximately 140 USD per barrel in 2008.
As well as high oil prices, the gaining acceptance of climate change caused governments, industry and consumers to adopt more energy efficient and environmentally friendly policies and solutions. Automotive companies focussed on designing private and commercial vehicles with lower fuel consumption, and hybrid technology and electric vehicles gained popularity.
Ever since the Treaty of Lisbon gave the European Union remit to develop an environmental policy, it has enacted legislation to encourage the adoption of energy efficient technologies in transport and infrastructure. Policy has also been focussed on the adoption of renewable energy sources and the encouragement of energy independence to limit external political influence on the European Union.
In part due to the financial crisis, the slow-down of both the European and Chinese economies, coupled with increased energy efficiency and development of renewable technologies, demand in oil decreased whilst production continued to increase.
In November 2014, the members of OPEC met in Vienna to discuss a multilateral reduction of production in order to maintain the oil price and thus stability. Most countries maintained an interest in reduction; however Saudi Arabia blocked this motion, resulting in OPEC production levels being maintained.
This result came as a surprise globally, and as a result the oil price dropped further. In total, over a six month period the global oil price more than halved from 115 USD per barrel in July 2014 to 50 USD in January 2015.
Many members of OPEC, as well as oil-producing non-members such as Russia are experiencing difficulties as a result of falling oil prices: each country has an oil price under which it cannot survive. Venezuela, Algeria and Iran as well as Russia are particularly affected, and national spending will have to cut which may cause unrest in the long-term.
The rationale behind this strategy is believed to be twofold. In the 1980s, Saudi Arabia responded to a similar situation by reducing oil production; the sinking oil price however did not stop as a result, and consequently Saudi Arabia lost market share in global oil production. In addition, it is generally believed that Saudi Arabia wishes to reclaim its market share from the United States, which has been supported by fracking, a high-cost process. Through low oil prices, the use of shale oil fields would become unprofitable, leaving only production from conventional oilfields to be profitable.
In the 1970s, the United States enacted a law preventing the export of oil as a means of achieving oil independence: whereas the US in recent years became the world’s largest oil producer, it remained fairly insignificant in relation to world exporters. In January 2015, the United States lifted this law as a response to the falling oil price in order to retain market share. Many are however concerned this will continue to flood the global oil market, thus exacerbating the problem.
The question remains what the future is for the oil price. As the equilibrium of supply and demand has been tipped resulting in excess supply, the oil price will only be stabilised when either demand increases to meet supply, or when supply decreases to meet demand.
Four scenarios will likely cause the rebalance of the macroeconomic equilibrium:
- Conflict further affects oil producing countries. This would reduce global supply; this is difficult to predict, however the current conflict with ISIS may reduce the oil-producing potential of affected countries.
- OPEC multilaterally reduces oil production. This scenario depends on the will of Saudi Arabia; based on statements made by King Salman, the successor of King Abdullah, current policy will not be changed at least for the short-term.
- Global production decreases. With current oil prices, many oil fields are unsustainable in the long-term. Even well-established drilling companies are feeling the effects, cutting or freezing wages, reducing jobs and mothballing more expensive projects. Fracking projects are proving unsustainable, discouraging further investment.
- Global increase in demand. This would most likely be driven by a significant increase in the economy, driving the consumption of oil. Given the adoption of energy efficient and environmentally friendly solutions, demand would unlikely reach pre-2000 levels for a long time.
The most likely reason for a future oil price increase will be a combination of several of the above scenarios.
Who will then benefit from the low oil price? Countries with strong agricultural backgrounds, in particular the developing world, transportation companies, the private individual and the world economy stand to benefit. The reduction of state subsidies on fuels will free up government spending and inflation will decrease; however this may encourage deflation. The low oil price gives governments the opportunity to implement major policies which will encourage energy efficiency and energy security. The global economy may even be kick-started into growth.
Please note that the views expressed are those of the author and do not necessarily represent or reflect the views of Munich European Forum e.V.