Thursday, March 17, 2016

Peak Oil Theory, OPEC, and the Price of Oil

Few commodities, if any, exhibit the type of variance in price as oil does. It wasn’t that long ago that a gallon of gasoline cost about $3 in most regions of the country. Currently, the same gallon of gas is selling for about half that amount—all due to the radical fall in oil prices.

Current events, as they relate to the price of petroleum, have sparked an onslaught of questions and inquiries from a wide array of stakeholders, including investors, oil company executives, politicians, economists, and environmentalists. Many of these questions and inquiries revolve around a similar theme: what is going on, and why?

What Is Peak Oil?

The concept of peak oil is extrapolated from a theory conceptualized by the geoscientist Marion King Hubbert. Hubbert’s theory postulates that for any geographic area, petroleum production eventually reaches a peak or maximum, followed by a terminal decline.

oil tanker
The concept of peak oil has obvious economic implications. In a market economy, supply and demand are the primary price determinants: when the demand for a product increases, prices will increase. Consequently, when the supply for a product exceeds demand, prices will decrease. These basic economic models of supply and demand apply to oil to the same degree as other commodities.

Economic models of supply and demand also apply to the current dialogue taking place regarding oil prices. Proponents who apply the peak oil theory to present events cite the drastic and unprecedented drop in oil prices as a potential indication that the world has reached maximum production. In July 2008, the price for a barrel of crude oil was $145—a record number. Currently, the same amount of oil is priced at approximately $37, which amounts to about a 75 percent decrease.

Coupled with this rapid decline in price is a marked increase in supply. These developments have led some economists and other experts to hypothesize that global oil production is approaching its peak.

OPEC’s Role

The Organization of the Petroleum Exporting Countries (OPEC) accounts for 40 percent of global oil production, making it a formidable influence on global oil prices. As a result of the drastic decline in oil prices, various countries are attempting to pressure OPEC leadership into cutting production in order to increase and stabilize the market price of oil. Algeria, Ecuador, and Venezuela—all OPEC members—have called for cuts in production.

However, Saudi Arabia, the de facto leader of OPEC, has not been willing to reduce supply. Industry observers note that in late 2014, the country made the decision that it would not decrease its production to counterbalance the new supply of shale oil from North American producers.

Instead, the Saudis opted to boost production and flood the market with cheaper oil, in an attempt to squeeze out North American producers and preserve its own sizeable market share. Essentially, the Saudi government is betting that it can withstand low oil prices until the threat of shale oil has diminished. To help shore up its finances, the government issued $5 billion worth of bonds in 2015 in its first entry into the bond market in eight years. Saudi Arabia’s central bank has also withdrawn up to $70 billion from foreign asset management firms, presumably in an effort to increase liquidity.

There are signs of a shift in this strategy, however. In late February 2016, the OPEC member countries Russia, Qatar, Venezuela, and most notably, Saudi Arabia, announced a tentative plan to freeze oil production at current levels. Oil prices rose in response.

Although reducing production seems logical in the face of falling prices, it can actually be risky from an economic standpoint. Any country that agrees to decrease output is consequently sacrificing its market share of a valuable commodity, something that many nations are hesitant about.

However, many economists insist that a true reduction in oil production, not a freeze, is the only sustainable and effective measure to shore up prices.

The Price of Oil

oil fuel price
The rapid and persistent drop in the value of oil has attracted the attention of various stakeholders. Understandably, corporate investors, executives, and workers remain apprehensive about the market. Whether favorable conditions materialize depends upon domestic and foreign supply, along with consumer demand, which shows no sign of slowing.

On the consumer side, Americans are reveling in the low cost of gasoline at the pump and the lower cost of other petroleum products. However, the global oil industry is hurting. More than 60 smaller oil and gas producers in the US have filed for bankruptcy, and last year, profits at the major oil companies declined to the lowest in a decade. In February 2016, BP reported a loss of $3.3 billion for the fourth quarter of 2015, while Exxon Mobile announced a 58 percent decline in profits during the same period. 

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