Falling barrels: Why oil prices are down 25%

20 Oct

Who will suffer and who will gain? Barrelperday blog is about to answer a lot of your burning questions below.

by Csaba Pogonyi, Péter Simon Vargha and István Zsoldos

Since mid-June, the price of oil has fallen by 25%, from around 115 $/barrel to under $90 (right now it’s $85!).


Barrels in free fall. Data: Bloomberg

Why is the oil price plummeting?

In a nutshell, the price is falling because suddenly (or not so suddenly) there is a lot of oil on the market:

  1. The shale boom is still going strong in the US. On average, oil production growth in the US alone is currently about twice as much as global demand growth.
  2. There are fewer supply disruptions in politically unstable places (even Libya is able to continue producing despite the ongoing fighting there), as opposed to a lot more disruptions over the past few years.
  3. Global oil demand growth is lower than it was previously expected as the global economy is slowing down together with that of China, the great oil-devourer of the last decade.

In addition, it seems there is a fourth point complementing the three above:

  1. Saudi Arabia decided not to intervene in spite of falling prices, meaning they are not cutting their production to achieve their target of 100 $/barrel.

How low will oil-prices fall in the short run?

We have been asked this question several times, and the media is rife with speculation on how far the price-drop could go. Truth be told, we have no idea. No matter what anyone says, in the short run there is no effective floor to oil prices. Neither on the supply side, nor on the demand side.

Even if prices are falling, the selfish incentive for all market players stays the same: to go on producing as much as they are able to sell. The reason for this is that these players have already spent most of the costs of production: they have paid for exploration and appraisal, drilled, built infrastructure, etc. (In the language of economists: these are sunk costs, and the marginal cost of continuing production is relatively low, so the price elasticity of supply is low.)

Neither will oil demand react to low prices in the short run: just because the price is down by 25%, people will not suddenly start driving a lot more.

And where are oil prices headed in the long run?

There is an ongoing discussion about the continuation of the American shale boom: what is the price level which would make it slow down? In the medium term (a couple of years), this level seems to be around $80, but new technologies are constantly evolving and these costs are not set in stone.

However, what seems to be likely is that this is the end for relative calm on oil markets. Prices were moving within a short band (roughly between $100-110), but now this stability seems to be over, so there is no guarantee that the price will soon settle again around a stable level.

OK, but what is the OPEC doing?

Above we wrote that none of the producers have an interest in cutting back production. So what’s up with OPEC, the oil producer countries’ cartel?

OPEC could moderate the price fall for years if it decides to cut production. However, at the end of the day OPEC is not independent from market principles. They produced 42% of the world’s total oil supply last year, and in the next years their share is expected to fall (see chart below showing data from the IEA).


It is not clear whether it would be beneficial for Saudi Arabia (by far the biggest OPEC-producer) to cut back its supplies. Even if they would successfully increase prices back to around $100, non-OPEC supply would continue its growth and the Saudis would have to cut their production further and further to maintain this price level.

The unbearable hardness of being in a cartel (a rule-of-thumb calculation)

If Saudi Arabia cuts it production unilaterally, they would be able to increase prices free-of-charge for a couple of months, but they would start losing in the longer run. According to an often used rule-of-thumb, in the short run a 1% cut in production increases the oil price by 10%. However, in the long run the price increase is a lot smaller. So if the Saudis decide to cut global oil production by 1%, prices would increase by 10%, but in the long run this would eventually moderate and prices would creep back down. Therefore, as Saudi Arabia provides around 10% of global production, in the short run their revenues would not change. However, later on they would start “paying” for their production cut: losing more on selling a smaller volume as they would gain by a higher price. So it is clear that it might only be worth for the Saudis to cut production if all OPEC-members agree to it.


The big question is, how reliable are other OPEC-countries? Individually all of them have the incentive to cheat and produce more. And most of these countries need the money even more and ASAP (see later).

Saudi Arabia has been here before… In the 1980s, they cut their exports to 3 billion barrels a day from 10, while other OPEC-members were cheating as much as they could get away with. At one point the Saudis became fed up and flooded the market with oil, which led to plummeting oil prices. Historical side note: the resulting oil price collapse is considered to be one of the reasons why the Soviet Union collapsed so fast.

So what are the Saudis thinking?

Everyone thinks that the Saudis have some strategy behind their „doing nothing” plan. In addition, everyone seems to grasp that for all practical purposes, OPEC means solely Saudi Arabia, just like we explained last year.

The following theories/speculations have been put forward to explain the current situation:

  • A secret deal with the US to punish Putin
  • They only care about market share, prices are not important anymore
  • They want to sustain prices in the medium run; therefore, they are pushing out non-conventional projects with a low price
  • They want to sustain prices in the medium run; therefore, they are pushing out the weaker (expensive) conventional projects with a low price
  • They want to sustain prices in the medium run; therefore, they are pushing out weaker OPEC members with a low price

Any combination of these options is plausible, and the Saudi leadership is notoriously inscrutable. However, it is also possible that the truth is simpler and duller: maybe they do not even have any strategic thinking behind their actions, with too much on their plate considering how much internal problems the country is facing. It can also happen that they will start cutting back in a month after they scared the other OPEC-members. From the tactical side, it is also possible that they just do not want to replay the slow-bleeding story of the ‘80s (see above).

What are the effects of lower oil prices?

Apart from everyone being happy while driving to the gas station.

The next chart shows the oil price level at which the 2013 state budget of these oil producing countries breaks even. Around 90 $/barrel, Russia, Iraq and Libya are running a strong deficit, whereas Saudi Arabia is still in surplus, together with Kuwait and the United Arab Emirates.


According to our calculations, the Russian budget would end up with a 5% deficit at a $90 price – providing that no fiscal adjustment takes place (which will). This is a stronger blow to Russia than the sanctions, no matter if it’s the Saudi-US deal behind it or not…

The golden age for oil countries is over: lots of them will not be able to continue raising living standards and at the same time increasing the army’s budget (or supporting foreign soldiers) without even running a budget deficit. This could lead to further upheavals and revolutions, which in turn can lower oil supply, working as a kind of (possibly temporary) correction mechanism… On the other hand, militias backed by oil money can weaken, which points towards a more peaceful world (hopefully).

The oil industry is also likely to react strongly: the willingness to invest decreases (which has started even before the oil price decline in the case of oil majors). They will start by abandoning the projects that break even only at a high oil price and on which they have not spent too much yet. This also leads to lower supply, but only many years later.

The global economy benefits somewhat from lower oil prices, but it may not be very obvious, as one of the triggers for the current fall is the slowdown in economic growth. Also, an 80 $/barrel oil price is still not exactly very low from a historical perspective…

This is why we do not expect a pushback (in contrast to the ‘80s) in efforts to developing electric cars and their batteries. Even at an 80 $/barrel price, the price of electricity is still around one-third of gasoline’s (without taxes), not to mention the environmental advantages…

If you liked the post, follow Barrelperday on Facebook!

Or subscribe to our Twitter feed or Newsletter

Tags: , , , , ,

Trackbacks and Pingbacks

  1. The oil story on The Economist covers in a single chart - Barrelperday - July 30, 2015

    […] we did not have to wait long. Oil prices dropped to below 50 USD/barrel, by more than 50% (here is our post on the reasons) and here is the new Economist […]

Leave a Reply