This Week's Focus: How much will last the collapse of oil?

This Week's Focus: How much will last the collapse of oil?


Oil barrel, after trading at highs of $ 130 in 2014, has continued to fall repeatedly. The week from 7 to 14 December 2015, has reached levels of $ 38, not seen since 2008, during the financial crisis.

What are the causes of this decline?

The first thing one thinks, being a vital raw material is in a decline in demand. As we discussed in our post What's behind the price of oil?, global demand remains at present relatively stable in the 92 million barrels, with trend growth of 1 million barrels annually.

The offer is partially controlled by the cartel of producers grouped in OPEC (Organization of Petroleum Exporting Countries). Currently, OPEC affects 40% of world supply, with Saudi Arabia who has traditionally absorbed most of the reductions in production to maintain or increase prices.

The countries that produce the lowest cost in Saudi Arabia, Iran and Iraq, between 20 and $ 30 per barrel.

Oil reserves, on the other hand, are at record levels, indicating that the actual supply has exceeded demand for a time, generating these surpluses, as demand has not declined significantly.

The reasons underlying the extraction of more oil than officially reported, have primarily to do with geopolitical reasons, but also economic. Countries like Venezuela or Russia, pumping at full capacity because they need the income from the sale of oil to keep its internal policies, albeit at a loss.

On the other hand, the depreciation of investments is included in the cost of production. Instead, once made the investment, the operating cost is significantly lower. Therefore, while the price to cover the operating cost, it is unlikely that the cessation of production awaiting higher prices sufficient to recover the investment.

Other countries such as Saudi Arabia itself, because they want to maintain their supremacy in the region of Middle East and so harm other competing countries such as Iran and Syria, allies of Russia. All this leads to the quotas set by OPEC (Russia is not a member, but the rest are themselves) are systematically exceeded.

What about the shale oil?

Recently, the US announced its energy independence by developing fracking technology to extract oil and gas from unconventional way. America has in its subsoil huge oil reserves that are now removable thanks to these new techniques.

The biggest drawback, its cost of extraction, has fallen as technology improved, and has risen from $ 75-80 per barrel to around $ 45 today. Hence, that, despite being private companies driven by economic profitability, many are able to continue producing.

The tensions in some producing countries of North Africa (Libya, Egypt, etc.), with the consequent interruptions in production, have been masked by the market entry of American unconventional oil. Once production has resumed in these countries, the market had excess supply.

Long-term changes in supply

It seems, then, that the supply curve has shifted, and that the global supply is now closer to an equilibrium price of $ 50 not $ 70 for just over a year. The slowdown in emerging economies may slow somewhat aggregate oil demand, although this is not clear.

On the other hand, the traditional recipe of OPEC to restrict production would increase the price to reduce the supply, does not have the desired effect and that the target price of $ 60 appears unconventional supply, which at that price is competitive.

The role of Saudi Arabia

What we must look then if in fact Saudi Arabia is the main architect of the current situation is the staying power that has the current price levels and even below them.

As oil subsidizes much of the operation of the Saudi kingdom, lower oil revenues mean that public deficits must be financed from accumulated foreign exchange reserves. The pace of deficit in 2015 (500 billion riyals), foreign exchange reserves endure three years unless drastic cut in public spending. In a country unaccustomed to paying taxes and cuts in public sector wages and subsidies, political stability could be at stake in the future.

Oil prices stable for longer than expected

In conclusion, although probably oversupply is absorbed in just over one year by the trend increase in demand, it is likely that oil prices range between $ 40 and $ 65 in the coming years. Below $ 40, the not cover operating costs lead to a reduction in supply in the short term. Above $ 65, the entry of new producers make it difficult for the price remains oversupply.

All this, unless demand increases more than expected, but recent agreements on climate change does not seem to favor this expectation.