What You Need to Know About Falling Oil Prices

Fuel prices have plummeted recently and don't show any signs of going back up as we step further into the new year. You might be asking yourself why this is happening.

The oil industry seems always to be fluctuating and changing, but this recent downturn is the worst that the industry has seen since the late 1990s, and possibly even earlier than that.

Companies that once made record profits are now struggling to keep the money coming in, leading them to stop production on many of their rigs and sharply cut investments in exploration and oil field development. Several smaller companies have gone completely bankrupt, and almost a quarter of a million workers have lost their jobs.

The cause of this crisis is the plummeting price of a barrel of oil. In the last decade, $90-$100 was the norm for a barrel of oil. Now the price has dropped to around $30 a barrel, with no sign of returning to the previous highs any time in the next year.

Why has the price of oil dropped so much?

Much of the reason boils down to supply and demand. In the United States, oil production is at its highest level in nearly 30 years, thanks to new technologies and techniques like hydraulic fracturing, which has made possible the exploitation of previously inaccessible shale deposits. In addition, U.S. crude oil inventories are higher than they have been in over 80 years.

The global oversupply is caused by surging production in other countries as well. Russia, a major oil exporter, has refused to decrease production to help stabilize prices—likely out of a fear that importing countries would respond by boosting their own production, thereby eliminating the market for Russia’s oil exports. Saudi Arabia, OPEC’s most powerful member nation, also appears determined not to cut production. Similarly, the government of Venezuela, another large oil exporter, has stated it will not end subsidies to oil producers.

Oil production is also set to increase elsewhere. In Iran, years of Western sanctions caused oil production to fall, and also barred the country from obtaining the most current technology and equipment from the Western world. However, these sanctions are now being lifted, and Iran is expected to see a boost in production soon. The country’s oil minister recently told CNN that it aims to increase its current output by 1.5 million barrels by the end of the year. Analysts are more conservative, estimating that Iran will be able to add between 600,000 and 1 million barrels to its current production levels in 2016.

However, there are also signs that production rates are dropping, due to a steep decline in exploration investments. The consulting firm Wood McKenzie identified 68 significant oil and natural gas projects around the globe that held a combined value of $380 billion and represented some 27 billion barrels of oil and equivalent natural gas amounts. These projects have been virtually halted since prices started coming down. In addition, Exxon has reduced its oil drilling budget to a 10-year low and has cut spending by 25% on gas terminals and rig leases. Royal Dutch Shell has backed off of costly exploration projects in Alaska. Oversupply, however, is still a global problem despite these developments.

Coupled with oversupply is weak demand. The economic outlook in Europe, several developing countries, and China is weak. China’s recent devaluation of its currency is a troubling hint that its economic woes may be more serious than many observers believe. In addition, automobiles are becoming more and more efficient, reducing the demand for fuel.

Who benefits from the price plunge?

That question is a bit easier to answer: in the short term, the consumer benefits the most from the price drop. Anyone faced with a daily commute can tell you how much gas prices have fallen. With the most recent decline, average gas prices in the U.S. hovered at $1.82 per gallon as of early February 2016. That amount is $.37 less than the previous average this time last year. Americans can now travel further for fewer dollars.

Who suffers the most from falling oil prices?

Many people might assume that it’s the oil companies taking the biggest hit, but that wouldn’t be completely accurate. For starters, oil-producing countries take an enormous economic hit. Russia, Nigeria, and Venezuela are just a few oil-rich countries that are suffering economic—and as a result, political—hardships due to falling oil prices.

Meanwhile, Chevron, Royal Dutch Shell, and BP have all been forced to make cuts to their payrolls. Despite that, they are still better off than smaller oil and gas producers, many of whom have had to sell off their assets and cut out dividends to investors after significant losses.

Unfortunately for the oil-producing countries and companies hurt by the drop in oil prices, there aren't any signs of recovery any time soon. Some balance could be recovered by 2016, but experts believe it will be marginal at best. 

A Look at the Impact of Falling Oil Prices

Much has been made about the recent drop in oil prices. Many people in the United States thought that they would never see gas below $2 a gallon again. However, gas prices are now well below this benchmark, and they continue to decline.

The national average price for a gallon of gas is $1.88, as of January 19, according to AAA’s Daily Fuel Gauge Report. The figure is down sharply as compared with the last 12 months, although gas prices have been falling for longer than that time.

Effect on Businesses

While consumers may be happy paying less for gas, businesses are feeling the effects in a decidedly less positive manner. The New York Times reports that roughly 250,000 oil workers have been laid off. Two-thirds of oil rigs have been decommissioned, and sales of oil production machines are down sharply.

While these numbers may seem shocking to many, a look at just how much oil prices have fallen shows why businesses in the oil industry have taken a serious hit. According to the New York Times, oil prices have fallen by more than 60% since June 2014. Current prices are at their lowest level in 12 years, in spite of the considerable inflation that has occurred during this time period.

Only a few short years ago, oil prices were $90 or even $100 a barrel. The price for a barrel of crude oil is currently about $28. The precipitous decline was unforeseen by the majority of analysts, as most expected OPEC (Organization of the Petroleum Exporting Countries) and other similar organizations to continue managing the supply of petroleum in such a way that prices remained high.

Too Much Supply

However, these organizations have failed to manage the supply as well as they did in the past. Over the last few years, oil production has risen sharply, particularly in the United States, Canada, and Iraq. Part of this increase in supply can be attributed to the advent of fracking in North America. The increased oil production in Iraq is frequently cited as an effect of the somewhat more stable political situation in that country.

The rise in oil production has begun to tail off, but the available evidence indicates that this will not immediately result in a large decline in oil prices. Stockpiles of petroleum products have increased to such a degree that there is more than enough oil for the long term, according to the New York Times.

Although production has begun to level out, there is further evidence that it will pick up again. New technologies are being developed across the industry, especially with regards to the practice of fracking. Moreover, the Gulf of Mexico and the oceans of Canada are expected to yield a great deal more oil in the future, as many drilling projects progress and new projects begin.

Decreased Demand for Oil

Another important factor in the drop of oil prices is the level of demand. With cars becoming more fuel efficient and the global economy remaining weak, demand is significantly less than had been projected in years past. To put it simply, fewer people are buying cars, and those who are on the road use less gas. The trend of fewer cars being sold is expected to end once the global economy improves. However, the fuel efficiency trend is only expected to accelerate.

Is the decrease in the price of oil good or bad? The answer is that it depends on one’s point of view. As with all major market forces, the effects of the drop in oil prices are widespread and complex.

Positive Aspects of Lower Prices

The positive aspects of the decline in petroleum prices are more visible than are the negative. The drop in gas prices is welcome by most adults in the United States who buy gas on a regular basis. The reduction in heating costs has also been quite noticeable, as many homes in the United States are still heated with oil.

The decrease in gas prices is more helpful to those under the poverty line, as they have roughly the same heating and gas bills as everyone else, but have less income with which to pay these bills. The savings are especially important at a time when food and housing costs have risen sharply.

However, the drop in gas prices has also had negative effects. Countries that depend on oil, such as Venezuela, have been hit very hard. These countries often struggle with issues of poverty and income equality, and they are more affected by a bad economy than rich people. The decline in oil prices may even threaten political stability, if a country that relies on petroleum is forced to make cuts to social programs.

A Guide to OPEC, Oil Prices, and the Global Economy

Oil continues to function as an increasingly important commodity, despite considerable advancements in alternative energy sources. Industrialized nations use oil to power their cars, heat their homes, and fuel planes that make international travel possible. Oil is also used in the production of common household items including shampoo, shaving cream, and even deodorant. It is not surprising, considering its many uses, that the presence of oil can make the difference between poverty and wealth in a nation or region. More than five decades ago, a group of five major petroleum-producing nations gathered and formed OPEC, an organization that has remained influential in the world since its inception.

What is OPEC?

OPEC stands for Organization of the Petroleum Exporting Countries and was founded in 1960 in Vienna, Austria. The organization was created by five founding members: Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela. OPEC has grown to include Algeria, Angola, Ecuador, Indonesia, Libya, Nigeria, Qatar, and the United Arab Emirates. Since Saudi Arabia is the most profitable oil producer in OPEC, it has become the organization’s de facto leader. Representatives from member nations meet semiannually at the OPEC Conference in Vienna, and the organization ensures each member has only one vote. Altogether, OPEC countries produce roughly 40% of the world’s crude oil, and their oil exports account for 60% of the international petroleum trade. In addition, more than 80% of the world’s “proven” oil reserves are located in OPEC countries. OPEC’s effect on the world economy is therefore substantial and cannot be ignored.

How does OPEC affect the global economy?

Because OPEC controls such a large share of the world’s petroleum supply, it has a major influence on the global economy. Regional and international politics can lead to an increase in oil prices, as it did from 1973-1974 during the oil embargo imposed by OPEC on the United States and other Western countries that took Israel’s side in the Yom Kippur War. The countries affected by this embargo then formed the International Energy Agency. A worldwide economic recession developed following the embargo, with unemployment and inflation rising considerably. Fuel rationing occurred in the US and some European countries until the embargo ended in March 1974. This incident demonstrates the severe consequences of an OPEC embargo and led nations to begin seriously considering long-term oil conservation and alternative sources of energy.

What else does OPEC do?

OPEC also wields influence in the international development sphere. In the 1970s, the organization established a Fund for International Development (OFID) to promote cooperation between member countries and other developing nations around the world. Some of its activities include funding humanitarian emergency relief, financing private sector projects, and extending loans for development initiatives and trade financing. The organization also finances projects in agriculture, education, health, and water and sanitation. Since its establishment, OFID has provided support to initiatives and entities in 134 countries.

How does OPEC influence oil prices?

Crude oil prices have fallen to a trading price of around $30 a barrel. This price is the lowest in 12 years. The reasons for the drop are complex, but a few big factors come into play. First, experts have cited high production as one of the causes—in December 2015, OPEC tossed aside production limits for its member countries, which it typically imposes to control prices, although member countries have often ignored these caps. Instead, OPEC effectively decided in favor of limitless production, in what industry observers say is an attempt to elbow other producers out of the market. Besides oversupply, experts also point to falling demand, particularly in China, as a reason for falling oil prices, while also claiming that the strength of the dollar contributed to the current situation as well. International politics are also partially involved, as Iran and Saudi Arabia ended diplomatic ties recently.

In general, supply is an important factor when considering oil prices and production. For many years, industry experts and academics have debated the true total extent of the world’s oil supplies.

What is peak oil?

Peak oil is a theoretical point in time when the maximum petroleum extraction rate is achieved, following which the rate continually declines. This theory is rooted in the observed rise, peak, fall, and end of petroleum production in individual oil fields over time. The peak oil theory has proliferated throughout the science and business communities, as well as the general public, since 1919, when it was first proposed by David White, then the Chief Geologist of the US Geological Survey.

While the theory has persisted for many years, the exact timing of this point—and even its existence—is a matter of hot debate. White incorrectly believed it would happen within three years of his proposal of the theory. The late geoscientist M. King Hubbert, who advanced the theory considerably, was also incorrect in his estimation that the world would hit peak oil in 2000. Today, some pundits predict that oil production will begin to decline after 2020.

However, the truth is that there is no consensus about peak oil. New technologies, such as hydraulic fracturing, have allowed for access to previously inaccessible deposits, effectively increasing the world’s supply. If other new technologies are developed, other deposits now considered inaccessible may be exploited in the future. Other matters that complicate the idea and timing of peak oil include the fact that many countries’ “proven” reserves have not been verified by independent audits, and there are economic reasons for them to overstate or understate their true numbers. 

What Is OPEC and Why Does It Matter?

The Organization of the Petroleum Exporting Countries (OPEC) is an association of sovereign nations whose economies largely depend on their oil reserves, which are exported and sold as petroleum. The members of OPEC say that they manage oil prices in such as way as to try to ensure fair prices for everyone. Members include Saudi Arabia (the de facto leader), United Arab Emirates Algeria, Angola, Ecuador, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, and Venezuela.

The organization aims to ensure that oil markets remain stable so that business investors in the member countries earn steady returns, producers receive a decent income, and consumers obtain a consistent petroleum supply. OPEC attempts to achieve these goals by controlling the amount of petroleum exported by its member countries, which in turn affects the price of oil through the basic economic principle of supply and demand. This does not always work, as seen in the current oil market. Too much oil has been produced, and the demand has not increased sufficiently to keep up with the supply. This issue happened before in the 1980s.

Membership in OPEC: Tightly Controlled and Deeply Political

OPEC began with just five members: Iran, Iraq, Venezuela, Kuwait, and Saudi Arabia. All of these countries have remained in the organization for the duration of its existence. Any prospective member has to be approved by three-fourths of the existing members. This number must include all of the founding members. Moreover, Saudi Arabia is effectively the leader of the coalition. The country produces the most oil by far, and it has the second largest number of reserves only behind Venezuela. One might think that Venezuela would have influence over Saudi Arabia due to its reserves. However, Venezuela has many problems in maximizing production, and Saudi Arabia’s leadership continues.

Moreover, Ecuador and Indonesia both left OPEC years ago, and they recently rejoined. Both nations initially left the organization due to problems with the production quota and rejoined in time to become mired in the recent slump in oil prices. While OPEC’s mission is to keep the price of oil steady, tensions between smaller producers such as Ecuador and Indonesia, as well as leader Saudi Arabia, have almost certainly contributed to the collapse of prices. Many of the poorer countries want to cut production in order to keep prices high. However, the Saudis are still making profits and refuse to cut production. This has led to tensions within the organization and rumors of some countries leaving.

Similar tensions led to the nation of Gabon to leave OPEC after nearly 20 years as a member. As with Indonesia and particularly Ecuador, they felt that they wanted to produce more than the quota determined by OPEC. Saudi Arabia effectively sets the quotas, yet it produces as much as it wants and makes billions of dollars on it every year.

The Troubled and Turbulent History of OPEC

OPEC began, somewhat ironically, in response to the actions of the most powerful oil cartel of the time. The “Seven Sisters,” a group of the seven most powerful oil companies in the world, controlled prices and supply. The group cut price several times, which angered the oil exporting countries affected by the decisions. The five founding members of OPEC got together and decided they wanted to be in control of the world’s petroleum markets for both financial and political reasons. The United States and several other countries that controlled the Seven Sisters had strained relationships with the oil exporting countries. This gave these countries a reason to want to distance themselves politically. Of course, the main motive was profit. The oil-rich nations saw that they could control their supply, and manage it in a such a way that they made enormous profits.

Accordingly, OPEC was founded in 1960 in Baghdad. After several years in Geneva, Switzerland, it moved to Vienna, Austria. There were some rumors of a move to Beirut or another city in the Middle East, but these proved to be unfounded. OPEC has been located in Vienna ever since, and all of its members maintain a year-round delegation of diplomats to handle their operations with regards to OPEC.

OPEC soon realized that it could increase its power with more members, and it expanded rapidly throughout the 1960s and 1970s. The Yom Kippur War in 1973 led the Arab nations to declare an embargo on the United States and other countries that had supported Israel. The war quickly ended, but oil price remained high for the time being, and distrust between the United States and OPEC was at an all-time high.

The nations of OPEC ramped up production as a result of the high oil prices, and soon there was too much oil, which lowered prices. This is much the same dynamic that has been observed in the last couple years.