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The Simple Reason For The Oil Price Drop

The Simple Reason For The Oil Price Drop

Don't worry. It's not complicated. 

I offer a simple explanation for the recent fall in oil prices in just two charts.

Oil prices move up and down in response to changes in supply and demand. If the world consumes more oil than it produces, the price goes up. If more oil is produced than the world consumes, the price goes down.

That's where we are right now. The world is producing more oil than it is consuming. The price of oil goes down. It's that simple.

The chart below shows when the world has been in a production surplus and a production deficit since 2008. Right now, we are in a production surplus so the price of oil is going down.


The important thing to take away from this chart is that the production surplus is smaller so far than the last time this happened between March 2012 and March 2013. Then, oil prices fell quickly but recovered in about a year. The difference between these two events, however, is that monthly average oil prices have fallen 27% so far but only fell 18% in 2012-2013.

Related: Are The Bakken’s Sweet Spots Past Their Prime?

The difference is found in quantitative easing (QE), the Federal Reserve Board's policy of pumping huge amounts of money into the U.S. economy.

QE ended in July 2014, the exact month that oil prices started falling. What a coincidence! This is shown in the chart below.


What is the connection between QE and oil prices? World oil prices are denominated in U.S. dollars so the more the dollar is worth, the lower the price of oil and vice versa. That's a well-known fact.

When the Fed started printing money like crazy after the Crash in 2008, the value of the dollar was kept artificially low compared with other currencies. The ever-weakening U.S. dollar dampened the impact of production surpluses and deficits on the price of oil.

Related: 5 Ways To Play The Oil Price Plunge

When QE ended in July 2014, the dollar got stronger and the price of oil went down as it always does when this happens. The coincidence of the end of QE with the onset of a production surplus created a perfect storm for oil prices.

There is nothing especially different about this latest oil-price fall compared to any of the others except the end of QE. It's not really about shale or the Saudi decision not to cut production. It's about a relatively ordinary oil-production surplus that happened at the same time that QE ended. And, there are few geopolitical fear factors now to mask the production-consumption balance as there have been in recent years (that will change, I am certain).
What's the message? Oil prices will recover and I doubt that we will see years of low prices as many have predicted.

By Arthur Berman

Source - http://petroleumtruthreport.blogspot.com/ 

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  • umnope on January 13 2015 said:
    Brent is below $50, so you probably need to update your chart.
  • TJ on January 13 2015 said:
    But the strong dollar could last for years (relative to low growth Eurozone & Japan; and slowing growth in China). And capex is being reduced, but production will increase in the US in 2015. Russia is pumping more as of Dec 2014. The OPEC countries dependent on oil will have to cheat quotas. On balance, production increases this year as fast or faster than demand increases. So why is this not a 2 year problem? What changes?
  • EM on January 13 2015 said:
    The graph show very little correlation between surplus/deficit and oil price.

    Plenty of times prices dropped when in production in deficit and vis versa.
  • Pedro on January 13 2015 said:
    Are you sure OPEC isn't keeping the cost below 65 bucks (magical profit number) to keep North America out of its pockets? Hard time buying the supply and demand argument here.
  • Paul Maher on January 13 2015 said:
    Hey, I have a couple of questions. Has the Divestment movement at the Universities, and most lately the Divestment of the Rockefeller Trust had any bearing on falling prices, and secondly is the LENR breakthrough and rollout coming in March or April of this year involved, and thirdly is the ever increasing sale of Electric Vehicles doing anything significant to oil prices?
  • Shantanu Bhushan on January 13 2015 said:
    Hi Arthur,

    Nice and simple analysis. However, would like to draw your attention on the period Apr 2012-May 2014. Do we see prices not following SS-DD gap theory?

    Thanks and Regards,
  • Reader on January 15 2015 said:
    Why is the production surplus showing as 0.5% in your chart? My understanding was that there's an oversupply of ~2mmb when the demand is ~90mmb?

    Isn't 2 / 90 = 2.22%
  • Luis D on September 05 2015 said:
    Unbelievable that I never saw this before. It is amazing what you can learn from just reading and educating yourself on these things. Thank you so much for this article. Now all I have to do is wait for QE 4 and by a ton of oil stock.
  • RH on March 23 2016 said:
    Buying oil stock nowadays should be synonymous with a fools errand. Many of the big oil companies are now digging into their reserves as they are losing large amounts of money due to the low oil price. There is effectively a price ceiling on oil prices due to the "fracking revolution", because it is so much cheaper and quicker to stop and start-up fracking operations, as well as much lower operating costs than say deep sea oil investing in big oil companies would be, in my opinion foolish.

    Please do yourself a favour and invest in something with better prospects.

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