Over the last six months, oil prices have fallen nearly 60 percent. While change is a constant in energy markets, the decline in crude oil prices over such a short time period has been unusually dramatic and prompted considerable speculation as to its causes and whether there is a conspiracy afoot, notably in Saudi Arabia.
Does the precipitous fall indicate a decline in demand due to sluggish Chinese and European economies, something that should give financial markets pause about global macroeconomic conditions? On the supply side, is the kingdom seeking to slap down Vladimir Putin for his Crimean incursions or support for Syria’s Bashar al-Assad? Undermine any rapprochement between the United States and Shiite Iran? Forestall American shale oil development?
While conspiracy theories entertain, the explanation for the oil price plunge appears to be a fairly straightforward supply-side story. Based on U.S. Department of Energy data, monthly global crude oil output has increased relatively sharply since May 2014, to a record level of 78.49 million barrels a day as of September 2014 (the most recent month for which data are available). The growth in output far surpasses the pattern from earlier in the year or for any of the prior four years following the Great Recession.
On the demand side, while Japan and Europe accounted for nearly all of a decline of 300,000 million barrels a day in OECD consumption, overall global consumption of petroleum and other liquids still grew by 1 percent in 2014.
A 2.3 percent increase in production may seem to be reasonably small. Could it be responsible for such a sharp decline in oil’s price? Definitely. Because the short-run responsiveness, or elasticity, of both supply and demand is fairly limited, even a small change in overall supply results in large price gyrations. When consumers cannot easily adjust their buying behavior nor suppliers their output over the near-term, price must do more of the work to equilibrate quantity supplied with quantity demanded. In 1999, the Riyadh Pact between Saudi Arabia, Mexico and Venezuela reduced petroleum output by 2 to 3 percent and led an increase of 250 percent in the price of oil, from $12 to $30 per barrel.
Now, consider Saudi Arabia, which has had to react to increasing global oil output and collapsing prices. Cutting output from 9.5 million barrels a day to 7.5 million to compensate for increasing production elsewhere in the globe since May 2014 and thereby counteracting the global oil price decline has some attractions. After all, selling 7.5 million barrels a day at $110 a barrel is more lucrative than selling 9.5 million barrels a day at $45 a barrel.
Why hasn’t the kingdom made this short-term tradeoff? On account of the longer-term tradeoff regarding when to sell its energy assets: specifically, how much should be disposed of today versus at some point in the future.
Fracking advances have altered this equation appreciably. Proven North American reserves have ballooned in light of the advances, behooving Saudi Arabia to pump oil sooner rather than later. Beyond the 67 billion barrels of North American shale oil reserves, the kingdom has even more to fear from the remainder of the world with 278 billion barrels. These currently proven reserves are bound to increase dramatically if entrepreneurial efforts and technology akin to what has been applied in North America are unleashed. For example, it has been speculated but not proven that Siberia’s Bazhenov formation alone could supply hundreds of billions of barrels of oil from shale—80 times larger than the presently estimated Bakken reserves of North Dakota.
In light of the foregoing, recent oil price gyrations and Saudi Arabia’s reactions to them make eminent sense. With the potential global impact of fracking, the kingdom has every incentive to try to keep the proverbial genie in the bottle so as to maximize the overall value of its energy assets.
The puzzle to an economist such as me remains why financial markets have not reacted more favorably so far to the dramatic oil price decline. I can partially understand the emphasis on the readily apparent damage inflicted on energy producers. I also can appreciate the potentially destabilizing consequences of energy-fueled autocratic regimes in Venezuela, Russia and Iran seeing their financial positions undermined.
Notwithstanding such considerations, I remain bullish on what the energy price decline means for global politics and economics. Restraining the means of oil-fed autocrats to inflict damage on their societies and the world at large is bound to be a good thing. And, the economic stimulus from the dramatic recent tax-cut-like drop in energy prices, while perhaps less immediately visible, is bound to be significant and positive over time.
Mark Zupan is Olin Professor of Economics and Public Policy and director of the Bradley Policy Center at the University of Rochester’s Simon Business School.
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