Dropping Oil Prices

Why did oil prices drop in 2014 and are why are they continuing to drop?

Oil is the most important natural resource and its price has been one of the most watched trends in economics during the 21st century.

Oil here refers to “crude oil”, i.e. the unrefined oil that occurs naturally in the earth’s surface. Crude oil can be refined to produce usable products such as petrol, diesel, plastics, and nearly everything we use today. The prices of all of these petroleum products tend to move together with crude oil prices.

Over the past two years, the price has dangerously fallen from $112 per barrel to below $30 per barrel. Numerous factors have contributed to this.

Supply > Demand

Supply being greater than demand is the most basic reason for the drop in oil prices. The demand for oil began to decrease due to weak economic activity of developing countries, increased energy-efficiency, and a growing transition from oil to alternative fuels. When supply exceeded the demand, there was a surplus of oil and hence the prices began to fall.

What’s interesting to note is that between 2010 and 2014, the demand for oil had sky-rocketed around the world as countries recovered from the financial crisis, and there was rapid growth and expansion in large economies such as China, Russia, India and Brazil. However, in 2014, by demanding less oil, these countries contributed significantly to the drop in oil prices.

Drop in imports due to local production 

From 2010 to 2014, when the prices were high, countries such as U.S. and Canada increased their efforts to produce their own oil. In the U.S., private companies began extracting oil from shale formations (sedimentary rock composed chiefly of a combination of silt and clay, may contain Kerogen, a type of organic matter that yields oil and gas) in North Dakota using innovative hydraulic fracturing and horizontal drilling techniques. Meanwhile, Canada did the same, extracting from Alberta's oil sands, the world's third-largest crude oil reserve.

As a result of this local production, the two North American countries were able to cut their oil imports sharply, thus further decreasing the demand for oil and creating a lot of spare supply. This again put a downward pressure on world oil prices.

Canadian and Iraqi oil production and exports are rising year after year. Even the Russians, with all their economic problems, manage to keep pumping. This has also contributed to the oversupply of oil.

Saudi Arabia

Saudi Arabia's actions also contributed to falling 2014 oil prices. In this situation of fast dropping prices, it had the option of cutting down production and sending prices upward again. However, it kept its production stable. There were three reasons for this:

(i) Saudi Arabia holds the largest oil reserves in the world and produces oil cheaply. Hence it can withstand low oil prices for a long time without any threat to its economy. It has nearly  $900 billion in reserves. Its own oil costs very less (around $5-6 per barrel) to extract from the ground.

(ii) Extraction methods such as hydraulic fracturing are more expensive and therefore not profitable if oil prices fall too low. By supporting low oil prices, Saudi Arabia hopes that countries such as the U.S. and Canada will be forced to abandon their more costly production methods due to lack of profitability. Hence, Saudi hopes for a long-term benefit by maintaining production at the same level.

(iii) The Saudis and their Gulf allies do not want to sacrifice their own market by curbing production as the market share will then be taken up by countries they detest such as Iran and Russia.

Conclusion

The drop in oil prices has not only put severe economic pressure on oil producers around the world but has forced people to look for sustainable alternative forms of energy production. There is growing concern that further steep declines in the price of oil may threaten the economic and political stability of oil-producing countries. No one knows for sure when the prices will rise again. Ultimately, the supply and demand dynamic trend is the thing that needs to be followed and will determine the future of oil prices.

-Supriya Lakhtakia