Why ‘cheap oil’ is here to stay

The sudden fall of oil prices since the middle of last year has turned the tables of economic calculus for better growth.

“Cheap oil is with us for some time.” The sudden drop of oil prices from $115-$120 per barrel early in 2014 toward $80, then $70, and recently bottoming even to $45 per barrel, had come unexpectedly as we enter 2015.

And the cheap price of oil is likely to stay with us for some time. Some corrections might return it toward $60 per barrel during the year. It could even remain in the thereabouts of $50 per barrel for some time. Yet, given past experience, $70 per barrel would still be cheap oil.

This occurrence is a culmination of market supply and demand for oil on a global scale. Changes on the supply side or on the demand side bring about volatility in the short run.

“Relatively low global energy demand.” One major reason for the low price of oil is poor world demand. Demand for energy has not recovered fully from the recession that hit the world economy after 2008.

Europe’s economic problems have lingered since that time. Together with Japan’s faltering economy, this group of nations constitute a huge force that has left oil demand less exciting for some time. Missing in these two regions are needed structural reforms that could not be fixed because of political failure to move forward.

The US economy has revived. But it has come from an experience of recession and very low growth. China, the other economic power, continues to grow in its demand but at a slower pace.

“Global supply of oil: glut.” The supply of oil is controlled by a few large producers and exporters of the commodity. It is an oligopoly of oil producers.

The OPEC (Organization of Petroleum Exporting Countries) is no longer as powerful as before, but it still has influence. It has been considerably weakened by the growth of traditional and new sources of supply of oil and other energy alternatives.

The regime of high price of oil that ruled for several decades was the incentive that led to explorations, discoveries, and new technologies. High price encouraged the search for new sources of supply.

First, new supplies of traditional oil and gas expanded – from the development of new finds in deeper off-shores to harsh arctic regions and from countries and continents.

Second, extracting technologies from alternative carbon deposits took off in development, especially in the United States where there exist large shale mineral deposits. The technology of “fracking” was developed to tap these deposits into “shale oil,” which is no different from petroleum.

Third, non-traditional sources of energy were developed and exploited: wind and solar power, geothermal energy, second-generation atomic power.

The new technological frontiers broadened the sources of potential supply for the future. As the United States (the biggest oil consumer) successfully employed fracking technology for oil extraction, its domestic needs for energy shifted to shale oil from imported oil where it could.

Thus, output from fracking displaced a large part of American demand for foreign oil. Being a huge consumer of energy, this shift in use has high impact on internationally traded oil. Excess supply and the fall of oil price are twin results.

“OPEC strikes again.” In the 1970s, OPEC was founded, led by Saudi Arabia, and the organization coordinated the output of its members so that they reduced total world supply. This resulted in the dramatic rise of the price of oil. In this way, oil producers basked in the bounty of high prices to finance their own prosperity and growth.

In this regime of controlled output, OPEC’s leader had an important role to play. Before 2014, Saudi Arabia’s role was as a balancer of oil supply, to reconcile the differences among its members and to adjust market shares while maintaining the high price of oil.

It would cut its own production or adjust it upwards as warranted by the situation. In this way, Saudi Arabia was a kind of regulator, sacrificing sometimes its own production, to attain a higher common good for OPEC (or for price stability).

In the current situation, OPEC is trying a different approach. OPEC, and Saudi Arabia, are not contracting their output to conform with the current high price. They decided not to contract output as would be warranted in the past. By continuing to make available their old output volume, they would create more glut in the market.

Economists would recognize this as the tactic of output wars: the objective is to bring down the price first. The glut in oil would force high priced producers to bankruptcy or to retreat from production until they could match their break-even price at least.

By forcing a glut in supply, high cost producers would be forced out of the market. The question then is, at what price would the new long term price be? $70 per gallon? $80?

OPEC’s current strategy targets US producers of shale oil. They are high cost. They represent the strongest apparent threat to OPEC. If they are forced off the field, there would be more oil imports by the United States.

At this point, we do not know how the US fracking technology’s production costs could be influenced. On surface, it seemed possible that scaling back the output of shale oil of high cost producers could happen. That would lead to expected reduction of total oil production and so push up again the price of oil.

This belief, however, could be mistaken. There may be economies of scale in shale oil production. Such economies are not reversible once they get attained in production. (Economies of scale means that the unit cost of production falls as output is increased.) The fracking industry is quite new, and the experience is yet to determine whether the high initial costs of production would fall rapidly enough to realize substantial scale economies.

If indeed scale economies are achieved, then it takes only further encouragement from the US government, through production subsidies, to get more oil at cheaper cost per unit of extraction. That could change the picture in the long run much more rapidly.

Therefore, the age of cheap oil appears guaranteed.

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