As anyone who has paid attention to the oil industry recently knows that the price of oil has plummeted in recent months. The reason for this is two-fold, and makes up the essence of economics: supply and demand. The supply side is rooted with both foreign and domestic sources: foreign producers have not cut production, and domestic ones have produced the biggest spike in production in years. From the demand side, global influences have pushed demand down, and both Europe and China have experienced slowdowns in their economy that has resulted in them consuming less oil. And any supply/demand curve will tell you, when supply goes up AND demand goes down, prices will fall.
The increase in supply has been the most interesting part of the story so far. Domestically, the evolution of drilling technologies has brought about a new era in oil and gas production. A combination of technologies, actually, hydraulic fracturing (fracking) and horizontal drilling has made available oil and gas deposits that had previously thought to be either physically or economically unavailable. As the technologies developed and the price of oil rose, producers saw a lot of opportunity open up. These opportunities have precipitated an increase in US production by 50% since 2011, up almost 20% even from last year. The boost in production as provided Texas with an adrenaline shot to their oil industry and given North Dakota an oil rush fever unlike they’ve ever seen.
The global supply has been maintained by foreign producers holding steady to their production volumes. While there are many significant foreign producers, none hold the clout that Saudi Arabia does. Saudi Arabia is the second highest producer of crude oil, and only became second when the US eclipsed them last year. They produce almost 10 million barrels a day of crude, and are still the world’s leader in total oil production at over 11.5 million barrels a day. And they’re not afraid to use their might to leverage political or economic influence. To the surprise of many, as the oil price already started to tumble, the Saudis decided not to decrease their own production in order to stabilize prices; this sent the price of oil falling even more, to now what is 50% of last year’s peak of almost $100 a barrel.
I have little doubt that the Saudis are using this opportunity to flex its influence and push the weaker producers out of the market. Their competition is all over: Russia, Venezuela, Libya, Nigeria, in addition to the other Middle Eastern producers. It has been speculated that the Saudis wanted to influence Iran & Iraq, or that they wanted to punish Russia for supported Syria’s civil war. I believe it was a blanket economic strategy, aimed at weeding out the more vulnerable producers and letting economic forces take them out of the supply pool. An artificially inflated price would only strengthen and encourage those producers, possibly making them more resilient in the future. Many domestic producers have been rapidly developing, acquiring a relatively large debt ratio in the process; the precipitous drop in price puts those producers at risk, and if sustained will force some producers out of the market. It will also force other firms to be more judicious with which wells they keep in production and whether they explore for more wells.
I think, as we see the price in oil ebb to the mid-40s, we will see some of our own domestic producers struggle. Some may be forced to close up. Such is the nature of economics; when rapid oversupply creates a glut, and prices plummet, only the strongest, most efficient can survive. It is this type of evolutionary economics that sorts out the strongest to continue to supply the market. As the market sorts out the producers best fit to supply, a natural price equilibrium should arise; at this point it will either be 1) a domestic supply shift; 2) a foreign supply shift; or 3) a demand shift.
A domestic shift would most likely arise from a decision on Keystone XL. Although there is much debate on how much of an impact it would create, anything that would facilitate easier transport of oil would bring the cost down for producers and increase their profits. I believe other shifts in price would only be ‘tweaks’, minor adjustments as producers enter or exit the market.
A foreign shift might result in Saudi Arabia finally deciding to make a supply adjustment, after becoming satisfied with a leaning of the market’s supply. Saudi Arabia still has plenty of cash in reserve to tide them over…estimates speculate that they have around $ 500 billion in reserve, possibly more. This decision will come down to how long Saudi Arabia will want to operate at profit levels less than desired. While the break-even point for the average Middle Eastern producer is around $30 per barrel, Saudi Arabia had a much lower point, at $5-6 per barrel. While it seems that Saudi Arabia could weather much lower oil prices, it should be considered that a significant portion of their national income is derived from oil, so significant profit margins are still desired. Which means that it will come down to the Saudis finding a balance between the global supply and their own cash reserves.
Demand will be the biggest wild card. Global demand is predicted to continue to slide through 2015, with both Asian markets and the Eurozone facing tough economic conditions. Global demand will be tougher to predict though, but will directly influence the price. Locally, the U.S. should see no signs of decline, as the economy is going very strong. Coupled with the cheap price of gas, less efficient vehicles should sell well this year, increasing demand further for gas domestically.