Why oil prices are going down

Gasoline and diesel prices have declined and are expected to continue declining. Electricity costs are also expected to go down. Jeepney fares have already been reduced. Bus, taxi and even airline fares are expected to follow.  Shipping costs and prices of consumer good should come down certainly after Christmas.

All these price and fare reductions have been compared to a tax refund or additional Christmas bonus for the people. This has added to the euphoria of this Christmas season and an extremely high (88%) confidence rating of the Filipino people looking forward to 2015.

Most people are aware that all these events are happening due to a drastic and sudden decrease in the world price of crude oil. During the past four years, oil prices stayed at around $110 per barrel. From approximately $115 per barrel of crude oil, the price this week has gone to a level of around $60 per barrel or a drop of almost 50% over a short period of six months.  

So what is the reason for this dramatic drop? How long will this low price of oil continue before we see it increasing to the old price levels again?  A working housewife recently told me that she was just happy that she had extra cash in time for Christmas shopping. But she assumes that sooner or later oil prices will again go up and fuel prices should go back to the old levels.

This observation is very important for those analyzing economic trends. The savings in fuel prices, transportation fares and consumer goods prices will be going to the average consumers and not to the very wealthy or the big corporations. Therefore, this fall in oil prices will likely result in bigger consumer spending and money not put away in sovereign wealth funds or money laundered to some secret bank accounts. This will help boost economic growth on a worldwide basis.

Economists are also predicting that the falling oil prices will keep inflation down and may even reduce prices of basic commodities. This reduction in inflation will encourage central banks, and maybe our own Central Bank, to keep interest rates which again will help maintain the current strong demand for housing and cars.

The Economist magazine recently projected that a $40 per barrel cut in the price of oil will shift some $1.3 Trillion from oil producers to oil consumers. The biggest beneficiaries of this fall in oil prices are the oil importing countries which includes the Philippines. Other countries that will benefit include China, Japan, India, and Turkey, Most emerging and poor countries of the world will be direct beneficiaries.

The biggest losers will be those countries whose production costs are very high or whose national budgets are dependent on high oil prices. These countries include Russia, Iran, Nigeria and Venezuela. Someone told me that the reduction in oil prices was to cause the downfall of regimes in Iran and Russia which are countries that Saudi Arabia and the United States consider unfriendly.

It is true that the fall in oil prices has already caused a recession in Russia, and if the prices remain at their current level will cause another recession in that country next year. Iran, Venezuela and Nigeria are also expected to be major losers if this price trend continues. Although these economic consequences are real, the motives are much more pragmatic.

In the past, the Organization of Petroleum Exporting Countries (OPEC) would reduce oil production if the prices start sliding. However, this year, Saudi Arabia, the world’s largest oil exporter, and the five Gulf States refused to cut oil production. Their strategy was to create an oversupply situation which would bring down the price of oil.

The main targets of this strategy are the shale oil producers in the United States, primarily in North Dakota and Texas. The main objective is to force the shale oil producers to either close down or reduce production. Saudi Arabia is extremely worried that if the shale oil producers continue increasing production in the United States and eventually in Western Europe, these countries will become self reliant in oil and stop importing from the Middle East. Not only will the Middle East lose their most lucrative markets but the Western powers may even give much less attention to the geopolitical conflicts in the Middle East.

The Saudi Arabian strategy is reminiscent of the rubber barons of the past in the United States. How do you drive out competitors? Normally you offer a better product. But crude oil is the same anywhere in the world. The only other recourse is offering a lower price that the competition cannot match.

Over the past four to five years, as oil prices went up astronomically, American oil entrepreneurs started extracting oil from shale formation. Shale is actually fissile rock composed of laminated layers of clay-like, fine grained sediments. Oil extraction from shale was considered unviable. However, a new technology was invented called “fracking.” This entails injecting a mixture of water, sand and chemicals into shale formations to release the oil.

The cost of producing shale oil is now estimated at $70 per barrel. If the worldwide price of oil is below $70, it is assumed that shale oil companies will stop investing in new oil fields. However, “fracking” experts are saying they can continue to reduce cost and that the production cost of shale oil is now down to $57 per barrel. On the other hand, Saudi Arabia has claimed that its oil has a production cost of $6 per barrel, the lowest in the world.

This is really a battle for market share between the shale oil producers of the United States and Western Europe and the oil producing kingdoms of the Middle East. For beneficiaries of this competition like the Philippines, let us hope this war will continue for a long, long time.

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