Recent months have seen the price of oil plunging from around $110 per barrel to below $60. At the depth of the Great Recession in early 2009, the price had once gone down to around $45, but it shot up within several months as the world economy slowly recovered. What causes this current plunge? Supply and demand is the ready answer. But how does it work for oil?
As we know, oil prices are controlled by OPEC led by Saudi Arabia. Due to its large reserves and production capacity, Saudi Arabia dominates the supply side. It drives the world price of oil by changing its production volumes quickly like no other producers can. In the latest OPEC meeting in November 2014, Saudi Arabia has persuaded the other OPEC members to stick with the current production levels in the face of collapsing world prices. Why?
The main reason is the rise of the United States as a major oil producer. The driving force is the new extraction technology called fracking involving horizontal drilling that forces out large amounts of oil and natural gas. The new technology requires heavy investments that will only realize positive returns when the oil price stays high at over $70 per barrel.
At the current low level, quite a few American oil companies have already started curtailing billions of dollars of drilling investments. The OPEC countries see rising US production as a threat. They want to keep prices low at present to frustrate US production. They are willing to sacrifice nearly half of their current oil incomes to do that. It is not clear how long OPEC can tolerate the low oil prices before they cut production to bring up the price again. As soon as oil prices go back up, high investments in US fracking will resume.
It should be noted that due to its huge appetite, the US is far from becoming a net exporter of oil to compete with OPEC. At present, the US still imports 40% of its total oil consumption despite reaching its peak in 2005 and declining since then. When the largest oil consumer in the world imports less because it can produce more, the ramifications are seen worldwide today as reflected in the downward price spiral.
The current collapse of oil prices has less to do with total world demand despite signs of recession in Europe and Japan. The major factor lies in the three big consumers — USA, China and India. The US is going through an economic recovery, currently growing at 3%. China’s growth has slackened but still registers a high 7%. The same is true with India at around 5%. The long-term demand for oil tends to go up when the appetites of these three big countries continue to increase.
In the meantime, the American consumers are happy to see prices plunging at the pumps. It is estimated that the savings at the pumps will result in billions of dollars of consumer spending that will be directed to the purchase of non-oil products, which will boost the current economic recovery.
The drop in oil prices will certainly impact the world’s environmental efforts. When oil prices come down, it will be harder to persuade consumers to save and switch to alternative energy. There will be less economic incentives to fight climate change. That is why education is important to help people understand the long-term effects of climate change and the negative consequences of burning fossil fuels.