Why Is the Price of Oil so Low?

What are the real reasons for the low oil price? This is the question analyzed by Vlad Gubernat, as the

Vlad Gubernat
Vlad Gubernat

This guest blog post is written by Vlad Gubernat. He is a full-time trader based in Romania who shares his thoughts on his blog, JLTrader.

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Hovering below the $50 level the price of WTI crude, the  American benchmark, has been cut in more than half since the highs of $107 reached in June 2014. It is now in a price range not yet seen since the depths of the 2009 recession, coming after a precipitous fall paralleling that in the second half of 2008 when we had the biggest financial crisis of past generations.

Source: FXCM
Source: FXCM

 

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Unlike those days though, when talks about the survival of the capitalist system entered mainstream media, we have a very different picture now. But judging just by the price chart of oil one might be forgiven if one believes that it isn’t so. What are the real reasons then for the decline we’re witnessing in oil prices ?

This is a complex question that runs the gamut from simple economics of supply and demand to conspiracy theories of US and Saudi Arabia colluding to drive the price down in order to punish Russia’s Putin’s for meddling in Ukraine. Starting off with the supply aspect of the equation, we first notice that America has become the world’s largest oil producer, with soaring extraction in Texas and North Dakota through hydraulic fracturing, or fracking. Though it does not export crude oil, it now imports much less, creating a lot of spare supply. Secondly, the continuing turmoil in Iraq and Libya – two big oil producers – has not significantly affected their output, as it was initially feared. Thirdly, Saudi Arabia and their Gulf allies didn’t want to give up market share and refused to cut production,  also hoping that lower prices would put a break on US shale boom.

Saudi Arabia looks determined not to repeat the mistake of the 1980s when they cut production by almost three quarters, but the oil price continued to slide anyway. Their incorrect approach resulted in years of budget deficits and lost market share. All the above factors have led to a steady rise in world’s supply of oil. When we look at the demand side of the equation, we notice that it hasn’t been able to keep up with the increasing supply. That’s because of slow growth in emerging nations like China and weakening demand in Japan and the Euro zone.

Considering the combination of weaker-than-expected demand and steadily rising supply, it isn’t difficult to understand why the price of oil is falling. As to the conspiracy theories, there isn’t any evidence to support them. To the contrary, for all intents and purposes, Saudi Arabia is engaged in a ‘price war’ with the US. What that means is that it’s relatively cheap to pump oil out of  Saudi Arabia, but it’s more expensive to extract oil from shale formations in places like Texas and North Dakota. So as the price of oil keeps falling, some US producers may become unprofitable and go out of business.

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