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Why Oil Prices Are About To Settle

Why Oil Prices Are About To Settle

If you are paying attention, you will be aware that oil prices have been falling dramatically since the end of June, losing over 20 percent from the highs at that time. This is bad news for investors in the energy sector and for the companies that produce the black stuff, but for the global economy as a whole it will provide an unexpected boost to growth. All energy costs are benchmarked against oil, so declining oil prices equate to declining energy costs, and that is a positive for growth. Whether you are benefitting from that or worried about your energy investments, however, there is one obvious question…”How low can it go?”

The answer, it seems, is not much lower.

The drop has been caused by two factors, one on the supply side, and one on the demand side. Supply of oil has been growing as unconventional recovery methods, primarily hydraulic fracturing of “fracking”, have gained ground, particularly in the U.S. At the same time, the growing demand for oil has come into question due to a slowing growth rate in China and the prospect of deflation in Europe. Economics 101 tells us that if supply is increasing faster than demand, price will fall.

Related: OPEC & Russia’s Vulnerability and America’s Ingenuity

Ultimately, though, the reason oil prices have continued to fall is because OPEC has allowed them to. That may sound somewhat cynical, but even as production in the U.S. and other nations has grown, the fact remains that OPEC member nations control 81 percent of the World's proven oil reserves. The U.S. may have overtaken Saudi Arabia as the world’s largest current producer, but the OPEC countries combined still call the shots.

It is interesting then that a prominent Saudi oil official was talking up the price this weekend according to this report in the financial times. The drop in oil prices really gained ground a couple of weeks ago when the Saudi government said that they weren’t going to act to cut production and bolster prices, so any suggestion of a turnaround is significant. Their attitude is understandable. They have a very low cost of production for their abundant oil, so allowing prices to fall as a lesson to America and other upstart frackers makes perfect sense, but there is a limit.

Saudi Arabia and many other major OPEC producers face a problem. The actual cost of extracting oil may be low, but that doesn’t mean that they would be happy with oil at say $50 per barrel. They need prices to remain somewhat elevated to pay for massive social programs that oil revenues fund. The “Arab Spring” showed what can happen if a populace is unhappy, even in what looked before like a relatively stable nation ruled by one party or family, so massive cuts in these programs are not an option.

Related: Saudi Arabia: Producing More Crude, Selling Less?

An IMF Gulf Cooperation Council report from October of last year indicates that at their baseline price of just over $80 per barrel in 2018 the budget of Saudi Arabia would be balanced.

Fiscal Balance

Anything below that and the country would be in deficit, meaning that some of those social programs essential to preserving stability would be in danger.

Of course it could be that the global economy, and therefore demand for oil will collapse completely and no amount of production cuts by Saudi Arabia and other OPEC nations will make any difference, but that looks unlikely. It is far more likely that things will stabilize and, faced with cuts to social programs that they cannot afford to make, Saudi Arabia will lead the call for OPEC production cuts. That won’t be enough to drive oil back up to over $100 in a hurry, but it should stop the freefall.

By Martin Tillier of Oilprice.com

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  • Bill on October 28 2014 said:
    The White House and Warren Buffets Rail Road have a big say in pricing and Warrens pockets are bulging because his little sleep overs stopped the Keystone otherwise prices would be much cheaper and many jobs would have found there way to the construction and future maint. Now Warren see's the light after making his Obama money from no Keystone it must be getting close because Warren bought the Phillips Petroleum pipeline lubricants division, go figure who is getting bent over again with this new lubricant deal. This is all fact and don't be confused Obama influenced that and now it is Hillary's and Warrens turn so get ready here they go again, Talk about a monopoly what about a Political Monopoly, solid criminal price Democrat fixing using the environmental tree huggers and now they will get burned, and what will or who will the environmental Guru's GO AFTER THAN MISS BENGHAZI!
  • David Hrivnak on October 28 2014 said:
    Don't forget another price floor is most oil fracking and tar sands extraction need about $80 to make cash flows on new wells. So it is very likely new drilling will slow if we drop below $80.

    Who knows maybe that of part of OPEC's plan. They want to slow the increase in the expensive unconventional plays.
  • Reality on October 28 2014 said:
    Everybody knows there is lots of fat money in the oil field. Lower prices may squeeze out some of the fat before they shut drilling down. Producers in North Dakota flared something like a billion dollars worth of gas to get at the oil in just one year. Maybe lower prices will help us slow down and not waste our resources like a bunch of oil intoxicated drunks!

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