Posts Tagged ‘Economics’

If you were buying gasoline for your car in 2008, then you are aware of how high gas prices were. $4/gallon is no joke ($147/barrel), especially if you are unemployed (which there was a 10% chance of at the time). World oil prices peaked at this time and were the highest ever recorded. The financial crisis is partly responsible for the sharp decline in prices between 2008 and 2009 (decreased demand) and I will explain in more depth below. Oil prices have historically been indexed to global economic prosperity (especially the U.S.), which is why we notice a steady increase in prices (increased demand) as government bailout funds slowly start churning the economy year after year until today (08′-14′). However, there has been a shift in the relationship between controlled supply (OPEC) and the price of crude oil ever since the U.S. has become its number one supplier of crude.





The price of oil has fallen by more than 40% since June 2014, when it was $115 a barrel. It is now below $70. Respectively, this translates into about $3.75/gallon and $2.50/gallon. This comes after nearly five years of “stability”. On November 27th, the Organization for the Petroleum Exporting Countries (OPEC), failed to reach agreement on production curbs, sending the price tumbling. The surge in supply has been the main catalyst in the plummeting price of oil. Weak demand has also been a major factor.

The oil price is partly determined by actual supply and demand, and partly by expectation. Demand for energy is correlated to economic activity. It also spikes in the winter in the northern hemisphere, and during summers in countries which use air conditioning. Supply can be affected by weather (which prevents tankers loading) and by geopolitical upsets. If producers think the price is staying high, they invest, which after a lag boosts supply. Similarly, low prices lead to an investment drought. OPEC’s decisions shape expectations: if it curbs supply sharply, it can increase prices. If it increases supply, it can decrease prices. Saudi Arabia produces nearly 10m barrels a day—a third of the OPEC total.


Oil prices have historically been cyclical.


Demand is currently low because of sub par economic activity, increased efficiency, and a growing switch away from oil to other fuels. America has become the world’s largest oil producer. Though it does not export crude oil, it now imports much less, creating a lot of spare supply. America used to be extremely dependent on foreign oil coming mainly from the Saudis; there has been a fundamental shift in American oil consumption. The American energy revolution, led by the new technologies of hydraulic fracturing and horizontal drilling, has created a flood of new shale-oil and natural-gas production that has overwhelmed world markets and driven prices down dramatically. The Saudis and their Gulf allies have decided not to sacrifice their own market share to restore the price. They could curb production sharply, but the main benefits would go to countries they detest such as Iran and Russia. Saudi Arabia can tolerate lower oil prices quite easily. It has $900 billion in reserves. Its own oil costs very little (around $5-6 per barrel) to get out of the ground. They are part of the OPEC price-fixing gridlock as of late.

The steep ascent in the price of oil between 2004 and 2008 coincided with the first significant decrease in non-OPEC supply since 1973 and an unprecedented surge in global demand. China increased its demand for oil from 7M barrels/day to about 10M barrels/day during this time period. Other growing economies, such as Brazil & Indian increased their demand for oil.  Although OPEC members responded by increasing their production, they lacked sufficient capacity after years of restrained field investments to bridge the growing gap between global demand and non-OPEC supply.

On December 12, 2014 the Dow Jones industrials lost more than 315 points, a 1.8 percent decline, to cap a weekly loss of 3.8 percent — the deepest drop since November 2011. The main reason why the stock market is losing steam is because people realize that the decline in global oil prices is great for consumers, but bad for energy corporations. Lower crude oil prices will put pressure on indebted, U.S. shale oil producers that invested heavily into fracking and other technologies.


Supply and demand diagram showing both OPEC-controlled and unconstrained supply curves. Described in text.


Overall, OPEC appears to be losing global influence, mainly because the United States is the main consumer of oil and is less dependant on OPEC than ever. As presented in the graph, OPEC controls the “low-cost” part of the supply curve. By exercising control and reducing output from where it would be in an uncontrolled, competitive market, they are able to shift the equilibrium from the competitive point (P*, Q*) to what I call the “OPEC” point: (P(O), Q(O)), which gives us a price that is higher than the competitive market price. Lately, with OPEC failing to curb supply, we’ve seen a drop in price from the “OPEC” point to the competitive point. Let’s hope that this paradigm shift continues along with a strong dollar in order to ensure economic prosperity.