What Cheap Oil Means For Us

Oil is cheap right now, and has been for longer than usual. The record-low oil prices of the last six months stem from an oversupply, helped by a boom in shale oil and other unconventional sources. In the past few weeks, falling expectations for oil demand, especially from China and Europe, have pushed prices down even further. The current glut of oil put the Organization of Petroleum Exporting Countries (OPEC) on guard as it tries to protect its monopoly power from the growing unconventional producers, notably, the United States and Canada. OPEC’s price war, however, has had many political and economic effects. Oil isn’t supposed to be cheap any more; its unusually low price threatens to upset the balance of power across the world. Oil-dependent countries are seeing their budgets vanish, as are massive energy companies who have been through decades of huge profits. Many oil-exporting countries are in unstable parts of the world, or face criticism of their autocratic policies, and may find it tough to preserve order or suppress dissent without fistfuls of oil money. On the other side, oil-importing countries, manufacturers, and consumers suddenly find their costs slashed. In the U.S., with gas prices hovering around $2.60 a gallon, it’s estimated Americans are saving $630 million a day.

While oil prices are notoriously difficult to predict, they are expected to stay low for the next six months and then stabilize at a higher, but still moderately low, price for the next few years. Suppliers typically determine the price of oil, because of its scarcity, with the largest supplier having the most influence on price. For most of the twentieth century, the U.S. was the world’s largest producer of oil, but domestic production peaked in the early 1970s and then declined. This change left OPEC as the largest producer and controller of oil prices, which they have carefully managed ever since. OPEC operates as a cartel, an organization that colludes to make the price of oil artificially high. The OPEC countries could theoretically increase production (or at least they could have 40 years ago) and easily meet the world’s oil demand, but by restricting production they keep prices high and ensure large profits.

Presently, OPEC’s productive capability may be nearing a peak, just as the U.S. did in the 1970s. In fact, growth in conventional oil production across the world appears to be slowing, if not reaching a plateau. Oil experts have always warned that the world’s oil supplies are finite, and both energy companies and environmentalists agree we ought to prepare for the eventual decline in world oil production, predicting a global peak early this century. But in the last five years the United States has nearly doubled its fossil fuel production and again become the world’s largest fossil fuel producer, counting natural gas along with oil.

Some reports claim that today’s energy boom will be short-lived, but for the present, the world enjoys more oil than ever before, and adherents of Julian Simon seem to have won another argument over resources. The U.S. happens to have some of the largest unconventional oil reserves, although they are expensive and difficult to recover. The U.S. Geological Survey estimates there may be up to 2.6 trillion barrels of technically recoverable oil shale in the U.S., of which about 1 trillion barrels may be feasible to recover (as compared to Saudi Arabia’s proven reserves of 268 billion barrels of oil). The existence of several other unconventional oil and gas sources such as tar oil sands, liquefied coal or natural gas, and methane hydrates have prompted some economists to speculate we will never run out of cheap energy. However, the Energy Information Administration predicts the current U.S. shale oil boom will peak in 2021 and then steadily decline again, allowing for only a decade of cheaper oil before another oil crisis (other environmentally-conscious sources think this peak will happen faster).

Prices for the Brent crude oil and West Texas Intermediate benchmarks dropped near $40 a barrel in late August. A small mismatch in oil markets can cause a huge price swing because both oil supply and demand are highly inelastic, i.e. not responsive to changes in markets and prices. When demand is high, oil producers cannot rapidly establish new wells or find more oil, and when demand is low, it is too expensive to stop long-term exploration or drilling projects. Shale oil contrasts with typical oil sources due to its ability to switch on and off wells and adjust production. Shale oil drilling is characterized by many short-lived wells; most wells decline in production by 80 percent in their first three years. Surprisingly, shale oil production has actually increased marginally over the first half of 2015.

Shale oil producers have made drastic adjustments but haven’t cut production yet because they found ways to maintain revenues, making shale oil cheaper. Oil producers cut the number of operating wells in the U.S. in half since mid-2014, but kept up production by exploiting their most productive wells, the “sweet spots” of shale fields, and eliminating any unnecessary or exploratory wells. But shale producers may only be able to hold out so long; shale oil production was not supposed to be viable under $50 a barrel. Producers are nearing the end of futures contracts signed months ago for oil at higher prices, as well as the end of storage capacity to hold oil off the market for better prices. Companies may also suddenly default on their loans as banks recalculate the value of their oil holdings based on lower prices. These complications mean either oil prices will be driven even lower, or oil companies will go out of business and reduce production (reduced production is expected through the rest of 2015 and 2016, until demand recovers).

Another reason why supply hasn’t reacted much is the difference between how OPEC responds to oil prices and how the U.S. responds. Oil production in most countries is so lucrative—dangerously so—that countries nationalize production, aligning the industry with national interests, which typically means maximizing profits, but can be manipulated for political goals. OPEC manages the cartel by suppressing competition amongst its members so they collectively benefit, despite the fact that if some members cheated the cartel by increasing production they could individually achieve greater gains than they get from membership. OPEC members have a surprisingly good track record of following their production quotas, so for the last forty years, the cartel has worked.

In the U.S. oil production is managed by hundreds of competing producers (not merely the five or six major energy companies as it may seem) and these companies keep prices down through competition: extracting as much oil as is profitable for their small company, rather than extracting just enough to charge a premium price. For the last few decades, U.S. production hasn’t been large enough for these competing business to bring down prices, but with the major growth of shale oil, the U.S. produces enough to challenge OPEC.

OPEC decided in November 2014 not to reduce their production in response to U.S. growth in order to protect their market share. Saudi Arabia and Iraq are leading OPEC now by producing more than ever before in their history. If OPEC dropped production it risks losing customers to American producers and then never getting their business back—oil markets could stabilize with the U.S. as the overwhelmingly top producer at prices more like $70-80 per barrel. Saudi Arabia and the other Middle Eastern countries are gambling that the U.S. producers cannot withstand prices under $50 a barrel and will have to shut down, allowing prices to rise again and OPEC to maintain its oil hegemony.

Somewhat inadvertently, this decision may have drastic political consequences, mostly for the OPEC members outside the Middle East. Venezuela, Nigeria, Ecuador, Libya, Algeria, and Iran (although Iran will be less affected if the nuclear deal passes) as well as non-OPEC states heavily dependent on oil exports such as Russia, Brazil, and Indonesia, face a crisis as they see major contributors to their economy and government budget slashed. The U.S., as the world’s largest oil consumer, benefits greatly from low oil prices, as do all countries that import more oil than they export. The political consequences of these oil prices seem so attractive to the U.S. that many have speculated they must be a conspiracy, but while cheap oil helps our foreign policy goals and consumption, the price war’s biggest casualties are U.S. unconventional oil producers.

For the first time in many decades, oil is being priced near its production cost, eliminating oil companies’ typical immense profits to the benefit of consumers across the world. Low oil prices were expected to increase global GDP by 0.5 percent, however, low commodities prices in general have weakened developing countries that are disproportionately reliant on commodities exports. despite the negative effect on energy companies. Economists also worry that low commodity prices are the sign of weak markets and another coming recession. The Greek debt crisis and China’s slower-than normal growth have shaken global markets, and with a strong dollar dampening exports and the potential for rising fed interest rates, the robust US economy may struggle to keep up its gains. Unlike the 2008 recession though, which began with the highest oil prices of all time ($145 a barrel), low commodities prices create opportunities for low-cost production, especially since many of the price drops are linked to oversupply rather than declining demand (demand is stagnant or rising slowly).

America remains a mildly bright spot in the world economy, and the average person only marginally invested in the stock markets should be able to weather the current crisis just fine.