January 11, 2015

Understanding the plunge in global oil prices

Oil prices are expected to remain low in 2015 and rise only marginally in 2016, as the debate over the recent sharp decline in oil prices continues.

oil

Oil prices fell sharply in the second half of 2014, from an average of $105 to the current $50 per barrel bringing to an end a four-year period of stability in price.

The decline, which is much larger than that of the non-oil commodity price indices may signal an end to what many industrial and agricultural commodities analysts dubbed as a “super-cycle”(what is a super cycle) according to a just released analysis explaining the sharp decline in global oil prices.

The Global Economic Prospects report 2015, which analyses the current fall in oil prices by comparing and scrutinizing previous episodes of price declines, say the fall in oil prices in the second half of 2014 qualifies as a significant event in oil and gas trends.

The report says between 1984-2013, five other episodes of oil price declines of 30 percent or more in a six-month period occurred, coinciding with major changes in the global economy and oil markets.

An increase in the supply of oil and change in OPEC policy (1985-86), U.S. recessions (1990–91 and 2001); the Asian crisis (1997–98); and the global financial crisis (2007–09) are some of the other events recorded in the report.
It says there are particularly interesting parallels between the recent episode and the collapse in oil prices between the years 1985-86.

It says after the sharp increase in oil prices in the 1970s, technological developments made it possible to reduce the intensity of oil consumption and to extract oil from various offshore fields, including the North Sea and Alaska.

After Saudi Arabia changed policy in December 1985 to increase its market share, the price of oil declined by 61 percent, from $24.68 to $9.62 per barrel between January-July 1986. Following this episode, low oil prices prevailed for more than fifteen years according to the report released on Thursday this week.
In other commodity markets, episodes of large price declines have mostly been observed in agriculture, typically associated with specific weather conditions. After reaching deep lows during the global financial crisis, most commodity prices peaked in the first quarter of 2011.

Since then, prices of metals and agricultural and raw materials have declined steadily as a result of weak global demand and robust supplies.  In contrast, oil prices fluctuated within a narrow band around $105 per barrel until June 2014.

Softness in the global economy was offset by concerns about geopolitical risks, supply disruptions, and production controls exercised by OPEC led by Saudi Arabia, its largest oil producer.

This factor, according to the Global Economic Prospects report 2015, in part reflected the willingness of Saudi Arabia and other low-cost producers to withhold output in support of OPEC price objectives.

The steep decline in the second half of 2014 intensified after a change in policy at the OPEC meeting in late November. By the end of 2014, the cumulative fall in oil prices from the 2011 peak was much larger than that in non-oil commodity price indices.

Long-term developments in supply and demand according to the analysis have also played important roles in driving the recent decline in oil prices.

In 2014, relevant events such as the geopolitical conflicts in some oil -producing regions, OPEC announcements, and the appreciation of the U.S. dollar, saw the oil prices rise.

Trends in supply and demand

Recent developments in global oil markets have occurred against a long-term trend of greater-than-anticipated supply and less-than-anticipated demand.

Since 2011, U.S. shale oil production has persistently surprised on the upside, by some 0.9 million barrels per day in 2014.

Expectations of global oil demand have been revised downwards on several occasions during the same period as economic growth disappointed.

Between July and December 2014 alone, the projected oil demand for 2015 has been revised downwards by 0.8 million barrels per day.

Global growth in 2015 is expected to remain much weaker than it was during the 2003-08 period when oil prices rose substantially. Further, the oil-intensity of global GDP has almost halved since the 1970s as a result of increasing energy efficiency and declining oil-intensity of energy consumption.

Changes in OPEC objectives

Saudi Arabia has traditionally acted as the cartel’s swing producer, often using its spare capacity to either increase or reduce OPEC’s oil supply and stabilize prices within a desired band. This however changed dramatically in late November 2014 after OPEC failed to agree on production cuts.

The OPEC decision to maintain its production level of 30 million barrels per day signaled a significant change in the cartel’s policy objectives from targeting an oil price band to maintaining market share, a narrow band around $105 per barrel until June 2014.

Softness in the global economy was offset by concerns about geopolitical risks, supply disruptions, and production controls exercised by OPEC (led by Saudi Arabia, its largest oil producer).

The last factor in part reflected the willingness of Saudi Arabia and other low-cost producers to withhold output in support of OPEC price objectives.

The steep decline in the second half of 2014 intensified after a change in policy at the OPEC meeting in late November. By the end of 2014, the cumulative fall in oil prices from the 2011 peak was much larger than that in non-oil commodity price indices.

In the second half of 2014, the U.S. dollar appreciated by 10 percent against major currencies in trade-weighted nominal terms.

A U.S. dollar appreciation tends to have a negative impact on the price of oil as demand can decline in countries that experience erosion in the purchasing power of their currencies.

Empirical estimates of the size of the U.S. dollar effect cover a wide range: the high estimates suggest that a 10 percent appreciation is associated with a decline of about 10 percent in the oil price, whereas the low estimates suggest 3 percent or less.

Although the exact contribution of each of these factors cannot be quantified with precision, it is clear that the dominant factor in the price fall has been changes in supply conditions, stemming from the expansion of oil output in the United States, receding concerns on supply disruptions, and OPEC’s switch to a policy of maintaining market share.

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