Will World Economy Slip On Crude Oil?

We don’t see crude oil in our daily lives. But numerous ways in which it touches our lives, will leave you stunned. Petrol, diesel and kerosene are the obvious derivative products of crude oil. But nylon, plastic containers, bags, tires, medical equipments, etc. are also made from by-products of crude oil.

So no matter who you are and what you do, the prices of oil have and will impact you on daily basis. Price of this commodity has the potential to bring down entire nations to their knees.

This is the reason why the world has a perennial affection for discussing crude oil prices.

And when we are regularly discussing investments and economic factors here, we should necessarily give some time to improve our understanding about oil prices.

World Oil Market

Till mid-2000s, production of oil was dominated by middle-eastern and OPEC countries. But after decades of decline, oil production in US started increasing rapidly. This was due to technological advancements which allowed extraction of oil from complex shale rock formations.

Russia too made tremendous headways in increasing its production, in order to increase its geo-political influence.

So now, even though OPEC countries are still the largest producer of crude oil (as a group), US has overtaken Saudi Arabia on a standalone basis. Third in list is Russia.

The table clearly shows that the clout which Saudi and OPEC had till few years back has now reduced. And this is the reason why OPEC is playing geo-political games to regain market share. We will come back to that in a bit.

Factors Affecting crude Oil Prices

Theoretically, prices should be determined by supply and demand factors.

Between 2000 and 2008, oil prices rose as global economic growth increased the demand for energy worldwide. But supply could not keep pace with demand and this resulted in oil reaching highs of $140 a barrel. The financial crisis of 2008 reduced worldwide oil consumption and this combined with increasing OPEC production, led to a collapse in prices.

Now crude oil has very dynamic and high-volume futures markets. So apart from actual demand and supply, prices also reflect traders’ own view of future demand and supply of crude oil. These views (aggregated) at times become so strong that they tend to severely impact actual oil prices.

But that’s not all.

There is another big factor that determines the direction of oil prices: Geo-Political Motives. And when that happens, forces of demand and supply take a back seat.

Why are Oil Prices Down Now?

Oil prices recently made multi year lows (<$35) and reasons for it are not hard to guess. The world economy is facing economic turmoil. China, the main engine of world’s growth has been plagued with internal problems and doesn’t seem capable of getting back to its high-growth days. So demand for oil is not increasing as earlier.

On the supply side, US has become the largest oil producer. Though it doesn’t export much, its imports have come down, thereby creating a lot of spare supply across the world.

The erstwhile oil kings, i.e. OPEC (mainly Saudi Arabia) have taken a unique step this time. Instead of cutting production to reduce supply and prop up prices, they have decided not to sacrifice market shares.

This move is expected to force high-cost shale oil producers to shut down. This will also bring serious financial difficulties for countries like Russia and Iran, which depend on oil revenues to pay for their social programs and investments.

So OPEC is actually trying to push the competition to the wall. And it can comfortably do it because low production costs allow it to make profits even at low crude oil prices. Add to this the fact that OPEC nations are sitting on reserves of almost a trillion dollars and it’s clear that they can withstand low prices for many years.

Their competition on other hand cannot. They will be forced to close down as their breakeven prices are much higher than the current prices.

So with closures, the production will fall and lead to recapturing of market share by OPEC. And once equilibrium is attained and production decreases, prices are expected to rise again.

Who Benefits & Who Doesn’t?

The current low price scenario has divided the world into three parts: ?

• First are non-OPEC (Russia, US, etc.) and weak-OPEC producers (Nigeria, etc.) which are losing money. Some of these countries lose a billion dollars worth of revenue with each dollar fall in oil prices.
• Second part is that of strong OPEC nations (Saudi, etc.) – which due to above discussed reasons, can still sustain for many years.
• Last are the lucky benefactors – countries like India that import oil for most of their energy requirements. These have benefited immensely from low prices as it has helped reduce the current account deficit. India is also getting a shot at increasing its energy security by purchasing resources abroad at distressed prices from producer countries.

Future of Oil Price

No one can perfectly predict the future of oil prices. But there are indicators that low oil prices are here to stay. OPEC will continue to flood the market as it has deep pockets. Non-OPEC supply will fall but not as drastically as everyone expects as these countries will not go down without a fight. Demand is also not expected to increase suddenly as main consumers like China are facing deep economic troubles.

So the gap between supply and demand will take some more time to narrow. Oil experts expect oil markets to move closer to some kind of a balance by 2017-18. But oil has a history of sudden spikes and crashes. Prices can flare up due to random geo-political conflicts or supply disruptions. They can also sink without warning if something like the fear of collapse of Chinese economy materializes.

As far as India is concerned, the overall impact on economy will be positive as inflation would remain under control and allow money saved on oil imports, to be used for more productive purposes. But till the time prices don’t recover, brunt would continue to be borne by upstream oil companies (producers).

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