On 27th November 2014, a meeting was conducted in Vienna by the OPEC (Organization of Petroleum Exporting Countries) to decide on whether to cut the production of oil in order to support the falling global oil prices. But they were unable to reach into an agreement because of the opposition from Saudi Arabia.
So the first question that has to come to every one’s mind is what is the reason for the recent free fall of global oil prices?
To answer this question, first we have to get an idea about shale oil. Shale oil is unconventional oil produced from oil shale (Oil shale, also known as kerogen shale, is an organic-rich fine-grained sedimentary rock) rock fragments. That means if a country has large amount of oil shale reserves, then it can also produce oil. But the problem is the extraction of oil from oil shale. It is a very complex, capital intensive process and the cost of producing oil is much higher compared to the traditional methods.
US has significant amount of oil shale reserves in their country. Still they didn't produce much oil using this method because of the high costs. But the picture started to change five to six years back. When we consider the oil prices from the period 2010 to 2014 we can see that the price was settled somewhere around $100 per barrel.
This was because of the demand from China and other emerging economies was good and there was some bottlenecks from the supply side because of the political uncertainties from Libya, Iraq etc. This has helped demand to stay always above supply and as a result the price was settled around $100 per barrel for a long period of time.
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| Price of crude oil WTI. Data obtained from www.nasdaq,com |
US energy companies smelled this as an opportunity to extract oil from oil shale. Because they estimated that if the price of the oil is in the $100 range, then even after considering the huge costs associated with the exploration activities, they can still make a decent profit. This insight helped the US energy companies to pump billions of dollars into shale oil production and they have received lot of capital. As a result the share of US in the global oil market has been increased dramatically. US were producing about 4 million barrels of oil per day till 2008. Since then it has been increased to 8.97 million barrels per day at the end of October 2014.
Situation was good till last September. But it started to change from September onwards. Political chaos in many countries started to abate. Libya’s production has recovered from 200,000 barrels a day in April to 900,000 barrels a day, while war hasn’t stopped production in Iraq and output there has risen to an all-time high level of 3.3 million barrels per day. At the same time global economy started to experience some sort of setbacks. Demand from China, which was the growth engine of the past decade got reduced. Similar trends were seen from all over the world. This lower demand coupled with an excess supply from US and other oil producing nations caused the oil price to fall from $100 levels to $65 levels.
The next question is why Saudi Arabia is not ready for a cut in oil production. Because they fear that if OPEC cut production, the price will again climb back to the previous levels and as a result they may lose the competitive edge in the global oil market because of the supply from US. The Bloomberg report written by Grant Smith reports that US is on its path to become the biggest oil producer in the world by overtaking Saudi Arabia (Full report can be read from here http://www.bloomberg.com/news/2014-07-04/u-s-seen-as-biggest-oil-producer-after-overtaking-saudi.html)
So Saudi Arabia needs to make the shale oil production in US unviable and unprofitable by making the crude oil price lower. But there is a very serious negative reaction to this. The major source of revenue for most of the biggest oil producing nations is from the oil trade. So if the price continues to hover around these levels, then it is going to have a very tough time for their economies, because they may have set their economic and public policies on the assumption that they will get around $100 per barrel for oil. So the revenue short fall will be huge.
A report from outside the box (Full article can be accessed from here http://d21uq3hx4esec9.cloudfront.net/uploads/pdf/OTB_Nov_26_2014.pdf) by Jawad Mian says that the current oil decline has potentially cost OPEC $250 billion of its recent earnings of $1 trillion. This explains the magnitude of the situation. At the same time in the same report he shared one interesting observation. Even though 50 percent of shale oil is un-economical at current prices, the median cost of producing shale oil came down to $57 compared to $70 last year. That means even at these price levels US can produce oil economically. So we are going to see a huge price war in the oil sector in the coming years.
How India will be affected?
Everyone knows that India is a net importer of petroleum products and we imports around 70 percent of our crude requirements. So this price falls going to be very positive for our nation.
Our current account situations will be improved because oil is the biggest contributor of our import bill. Every dollar fall in oil leads to 4000 crore saving for India.
Also this is going to have a positive impact on our inflation front too. According to a RBI report (2005), for every unit dollar increase in crude oil price, WPI inflation rises by 30 basis points. Obviously every unit dollar decrease should also have some positive effects.
Economists around the world predict that this is not a temporary phenomenon. This price level will be maintained in the years to come. For India “acche din aane wale hai” :)
References
Situation was good till last September. But it started to change from September onwards. Political chaos in many countries started to abate. Libya’s production has recovered from 200,000 barrels a day in April to 900,000 barrels a day, while war hasn’t stopped production in Iraq and output there has risen to an all-time high level of 3.3 million barrels per day. At the same time global economy started to experience some sort of setbacks. Demand from China, which was the growth engine of the past decade got reduced. Similar trends were seen from all over the world. This lower demand coupled with an excess supply from US and other oil producing nations caused the oil price to fall from $100 levels to $65 levels.
The next question is why Saudi Arabia is not ready for a cut in oil production. Because they fear that if OPEC cut production, the price will again climb back to the previous levels and as a result they may lose the competitive edge in the global oil market because of the supply from US. The Bloomberg report written by Grant Smith reports that US is on its path to become the biggest oil producer in the world by overtaking Saudi Arabia (Full report can be read from here http://www.bloomberg.com/news/2014-07-04/u-s-seen-as-biggest-oil-producer-after-overtaking-saudi.html)
So Saudi Arabia needs to make the shale oil production in US unviable and unprofitable by making the crude oil price lower. But there is a very serious negative reaction to this. The major source of revenue for most of the biggest oil producing nations is from the oil trade. So if the price continues to hover around these levels, then it is going to have a very tough time for their economies, because they may have set their economic and public policies on the assumption that they will get around $100 per barrel for oil. So the revenue short fall will be huge.
A report from outside the box (Full article can be accessed from here http://d21uq3hx4esec9.cloudfront.net/uploads/pdf/OTB_Nov_26_2014.pdf) by Jawad Mian says that the current oil decline has potentially cost OPEC $250 billion of its recent earnings of $1 trillion. This explains the magnitude of the situation. At the same time in the same report he shared one interesting observation. Even though 50 percent of shale oil is un-economical at current prices, the median cost of producing shale oil came down to $57 compared to $70 last year. That means even at these price levels US can produce oil economically. So we are going to see a huge price war in the oil sector in the coming years.
How India will be affected?
Everyone knows that India is a net importer of petroleum products and we imports around 70 percent of our crude requirements. So this price falls going to be very positive for our nation.
Our current account situations will be improved because oil is the biggest contributor of our import bill. Every dollar fall in oil leads to 4000 crore saving for India.
Also this is going to have a positive impact on our inflation front too. According to a RBI report (2005), for every unit dollar increase in crude oil price, WPI inflation rises by 30 basis points. Obviously every unit dollar decrease should also have some positive effects.
Economists around the world predict that this is not a temporary phenomenon. This price level will be maintained in the years to come. For India “acche din aane wale hai” :)
References
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