Published on October 16th, 2014 | by Sara Vakhshouri5
Explainer: The Oil Price Plunge
by Sara Vakhshouri
In the past several days—despite the conflicts affecting Iraq, Syria, Iran and Russia—oil prices have been on a downward trend, hitting their lowest number in the past four years. As of October 2014, oil prices are more than 20 percent lower than June. This trend started with Saudi Arabia reducing its crude oil prices without cutting its production—the result of a strategic shift in Saudi policy. Previously, the swing producer in the market would maintain a general higher price range. Now it has shifted to increasing market shares by offering lower prices to its customers. Iran, the United Arab Emirates (UAE) and Iraq also followed the kingdom’s lead and offered discounts on their crude oil in order to maintain their market share.
This raises a number of interesting points. On the one hand, the acceleration of higher energy efficiency, combined with higher energy prices, the economic crisis in Europe and lower economic growth in China have all put pressure on overall energy demand growth. On the other hand, the global energy supply has had a bullish growth mainly because of the shale oil boom in North America and Iraqi oil output. Yet the lower growth of demand and the higher rate of supply growth have both altered concerns over energy security paradigms, shifting from the security of supply to concerns about the security of demand and the profitability of oil production (in the case of unconventional oil). Keen competition among producers to maintain market share, concerns over the unconventional oil production’s profitability, and the effect of lower oil prices on oil dependent economies are all consequences of this broader change in the balance between supply and demand in global energy markets.
Stabilizing the Demand
Although it might take longer to see the real effects of lower oil prices on global oil demand growth, lower oil prices will have a positive effect on the demand side. Lower prices could particularly strengthen the demand in countries that lack fuel subsidy regimes as price fluctuations may have a more tangible effect on consumers.
Oil Dependent Economies
The economies of conventional oil producing countries (particularly OPEC producers such as Bahrain, Kuwait, Saudi Arabia, Iran and Iraq) are highly dependent on oil for around 80 percent of their national budgets. There is a close correlation between oil prices and their fiscal maneuverability. For example, Russia, Nigeria, Bahrain, Venezuela and Iran have national budgets that work under a scenario of $100 per barrel of oil. Saudi Arabia’s budget for 2014 is meanwhile based on oil at $90 per barrel, and remaining OPEC members have set their 2014 budgets according to a $70 per barrel range. The current drop in prices has the potential to negatively affect some of these countries’ economies. But on the flip side, it could also encourage them to reduce their dependency on oil revenue in the medium to long-term. Lower oil prices also reduce the gap between global market prices and local prices, decreasing the amount of subsidies these countries have to pay for domestic fuel consumption.
Unconventional Oil Production
The extraction of unconventional resources does not only require a high level of technological proficiency, it is also very costly compared to conventional production. For most of the United States’ tight oil resources to be economically developed and produced, oil prices should remain at least around $70 per barrel in the long-term. With current costs, it is expected that the overall tight oil production will drop to about 20 percent with a downturn of oil prices below $70 per barrel. If oil prices drop below the range of economically profitable production, the drilling of new wells, for maintaining production levels, will mostly stop and tight oil production will reduce significantly within a period of between three to six months. The more recent price drops have reduced the profit margin of investment in US unconventional oil resources and have reduced the gap between current global oil prices to shale oil production costs to about only $20 per barrel. This has raised concerns for investors and could affect the likelihood of their further investment in unconventional oil extraction.
Back to Iran?
As I mentioned earlier, the costs of unconventional oil extraction are much higher than conventional oil production, particularly in the Persian Gulf region. Lower profit margins due to lower oil market prices could divert investor attention and interest back to conventional oil production in the Persian Gulf. Sanctions aside, Iran could possibly benefit from this situation due to the political and security crisis in Iraq. Indeed, due to the ongoing attacks by Daesh (ISIS or ISIL) in Iraq, most international investors have left the country. Iran, with its new investment regulations, could accordingly attract foreign investors to its energy industry once again. However, lower oil prices and high competition among the major oil producers to maintain and increase market shares could increase the stakes in maintaining the limitations on Iran’s oil exports and prevent this country from increasing its production.