What’s Fueling the Drop in Oil Prices?

How long will it last? Who wins & loses from it?

On the New York Mercantile Exchange, a barrel of light sweet crude is currently worth well under $60. Prices have dropped more than 25% in a month and almost 45% year-over-year. What is behind this free-fall? How long will prices keep dropping, and who does this development hurt and benefit?1

Oil prices haven’t cratered simply because of lessening demand. Make no mistake, waning demand is a major factor – and in its latest 2015 forecast, the International Energy Agency projected global demand for crude weakening further. But this is just part of the story.2

Saudi Arabia has made a punitive political move. It is the big player among OPEC nations, and it sees no point in thinning the crude supply glut. The longer it lasts, the more pressure it can put on two of its biggest competitors – Iran and Russia.3

Saudi Arabia has long feared Iran’s potential to develop nuclear weaponry, and if there’s too much oil on the market, the economy of Iran – which is extremely dependent on oil – could very well tank. Iran’s currency reserves are diminishing to the point where it needs oil prices up at the $130-140 level to balance its budget. Saudi Arabia has about 10 times Iran’s currency reserves, so it is much more equipped to ride out this oil bear market. Given enough economic pressure, Iran could finally make a deal with the world’s superpowers to wind down its nuclear program and signal to the Saudis that “enough is enough.” Russian president Vladimir Putin just told reporters that such a deal was “very close.”3,4

Speaking of Vladimir Putin, Russia has long supported the governments of both Iran and Syria – to much bad publicity, and now to its economic peril. Like Iran, Russia is a major oil supplier. It needs oil prices above $100 for any kind of economic stability, which it certainly lacks at present. No one has faith in the ruble, which has sunk against other currencies – and in response, Russia’s central bank just hiked its key interest rate by 6.5% to try and rescue it.5,6

Iraq and ISIS – the first making money from oil legitimately, the second illegitimately – are also punished by OPEC’s decision to sustain supply.

How will other emerging-market economies handle this tactic? Some might fare better than others. It might exacerbate the appalling economic conditions in Venezuela; it might foster additional unrest in Nigeria, where oil contributes to a third of GDP. Brazil and Mexico aren’t as reliant on oil as they once were; their economies might be able to weather the price drop in the short term, but not if the downturn in prices becomes a “new normal.”6

An oil glut could even give the economies of China and India an indirect lift. How? China imports massive amounts of oil and has very little oil and gas reserves – so inexpensive crude is a real gift. China spends about $500 billion a year on oil and gas imports, and it could actually end up halving that cost thanks to the plentiful global oil inventory. That could give its powerful economic engine a tune-up. India, too, is a major oil importer. About 75% of the oil it uses comes from overseas. Sustained cheap oil might soon improve its growth as well.6

What would this do for America? Well, cheap oil can translate to cheaper consumer and producer prices, i.e., lower inflation and more money in household wallets. While energy shares took severe hits this month, in the big picture this may bode well for consumer spending, manufacturing and the service industry.1

Could we actually see $60 oil for a year or more? Maybe. In fact, some oil industry analysts think West Texas Intermediate crude prices will head below $50 by February or March. World oil supply is still increasing, and inventory should continue to swell with no sudden pickup in demand being forecast.7

While $55 oil sounds cheap, you could argue that it really isn’t. In inflation-adjusted terms, the average price of WTI crude since 1985 works out to slightly above $40 per barrel. Still, inventory will decrease at some point. Analysts at the energy-focused investment bank Tudor, Pickering & Holt recently predicted that “the current oil price is going to crunch supply by late 2015/2016” and OPEC may change its stance if Saudi Arabia gets what it wants in the next few months.8

Citations.
1 – markets.on.nytimes.com/research/markets/commodities/commodities.asp [12/18/14]
2 – proactiveinvestors.com/companies/news/58785/dow-drops-over-300-pts-to-end-worst-week-in-3-years-58785.html [12/12/14]
3 – business.financialpost.com/2014/11/13/lawrence-solomon-saudi-arabias-war-of-attrition/ [11/13/14]
4 – reuters.com/article/2014/12/18/us-iran-nuclear-putin-idUSKBN0JW1BM20141218 [12/18/14]
5 – bloomberg.com/news/print/2014-12-15/russia-increases-key-interest-rate-to-17-to-stem-ruble-decline.html [12/15/14]
6 – nypost.com/2014/12/14/saudi-arabias-oil-war-against-iran-and-russia-2/ [12/14/14]
7 – tinyurl.com/qxjlt25 [12/17/14]
8 – forbes.com/sites/christopherhelman/2014/12/01/after-a-bloodbath-in-oil-what-next/ [12/1/14]

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