Oil Price Fallout: What Happens Next?

[Economics Club IIT Delhi]

Oil producers are in shock, and consumers are shockingly happy.

The last six years have proved just how fluid the international oil market is. Gasoline and oil are at their lowest prices since 2008, a year that saw oil peak at record highs of $140 a barrel before plummeting to just below $50 by year's end, roughly where it stands again today. Those prices are largely dictated by the Organization of the Petroleum Exporting Countries' so-called spare production capacity—that is, the amount of production OPEC (which accounts for 60 percent of petroleum traded internationally) can bring online within 30 days and sustain for at least 90. Spare capacity is robust at present thanks to factors like a slow-paced world economy, curtailed oil demand due to conservation efforts and concern about greenhouse gas emissions, and the fact that many countries have upped their domestic production and thus reduced their imports. One of the most notable new producers is the United States, which has seen a boom in oil and natural gas production thanks to hydraulic fracturing (fracking) applied to abundant supplies of shale.

Many OPEC members, like Iran, Iraq, and Venezuela, are running budget deficits, even with oil revenues. If their revenues drop, whether from limited production or falling oil prices, they're going to have big problems with their governments. In some cases, it could even cause a revolution. And we're reaching that point right now, where there's simply too much oil and not enough demand.Saudi Arabia is the anomaly among OPEC producers. It accounts for about 70 percent of spare production capacity, according to the International Energy Administration, and therefore has much more budgetary freedom with which to manipulate the world oil market. After having been rebuffed by other OPEC producers recently in pushing for production limits, Saudi Arabia is now content to stand pat and let the market fix itself.

One reason OPEC's hold on the world oil market has loosened is that the U.S. has quadrupled its oil production over the last six years thanks to fracking, a complex technique that combines both vertical and horizontal drilling and uses highly-pressurized water jets to force fossil fuels like oil and natural gas up from otherwise-unreachable rock beds. This new technology has enabled U.S. companies to access some of the estimated 36 billion barrels of "proved oil reserves" in this country, a number that has increased five years in a row.

The precipitous decline of oil prices also threatens the long-term viability of some of the country's shale oil projects. Shale oil is expensive to harvest and becomes prohibitively so as oil prices fall. And this is to say nothing of emerging concerns about both the relatively short lifespan of shale wells and the environmental dangers inherent in the process: related earthquakes, exorbitant water needs, and the release of methane gas, to name a few.

Meanwhile, consumers continue to enjoy paying much less at the gas pump. Unfortunately, low oil prices won't lower the costs of other goods or services significantly. Oil prices mostly affect transportation so low prices don't work their way through the system as much.

So what would it take to drive up the price of oil again?

The quickest thing would be an OPEC agreement to cut production by 3 or 4 million barrels. Beyond that, any political unrest in OPEC countries or even conflicts between them could cause prices to spike. Despite a lot of new production methods, the reality is that the world consumes more than 80 million barrels of oil per day. So if that spare capacity gets low suddenly, prices could go right back up. It doesn't take much.

Regards,

The Economics Club Team

[Himanshu Joshi]

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