The price of oil – it’s a mystery!

Black gold is no longer as precious as it was: in six months, its price has dropped by half! Where do these extreme fluctuations come from – and can anyone predict the next ones? The answers run the gamut from the economy, politics and marketing, to the moods of the various stakeholders.

After peaks of more than $100 in June 2014, oil* dropped to $45 during the winter, to stabilize around $50. Such a sudden plummet is not without its effects, not only on the price of petroleum products, but also on exchange rates, financial markets, and thus on the whole economy. In barely a few months, Canadians have seen their bills for gasoline and heating oil drop, but they have also lost their purchasing power when they purchase and travel in the United States.

Alas, no one can predict these price movements, or their duration. Without a crystal ball, the moods of oil are just as impenetrable as its colour. Unlike natural gas, whose prices are relatively stable and should remain low in the long term, the prices of petroleum products can rise at any time.

Supply and demand

Economists have identified certain key factors that influence the price of a barrel of oil.

First, world growth is declining. China and emerging countries are experiencing a downturn, while Europe continues to stagnate. Result: growth in demand is slowing. Oil is still being sold, but less than had been anticipated. This does not bode well for supporting stock market prices.

When it comes to supply, production has increased. Technological progress has led to the exploitation of new kinds of deposits in North America, notably in shale oil and oil sands. Between 2009 and 2014, American supply rose from 5 to 9 million barrels per day!

A basic economic principle is that when supply exceeds demand, prices drop – hence the cooling off in prices at the end of summer 2014. But this economic model is not enough to explain the magnitude of the fall that followed.

In an ideal market, supply could have been reduced to balance prices; in other words, it would have been sufficient to close the tap a little to adjust the flow of oil on the market. But that flow is subject to factors that go beyond simple plumbing!

First, the new North American forms of exploitation are expensive, and the investment cycles between exploration, extraction and transport are very long. When oil was approaching $100, that was not a problem; when prices dropped, the returns became much less attractive for producers. They abandoned their future projects but they still have to complete those under way, so they were unable to quickly reduce their costs in reaction to the drop in prices.

But the explanation is still incomplete.

Brutal competition

While North American producers tried to lessen the shock, their counterparts in the Organization of Petroleum Exporting Countries (OPEC) did nothing to help.

Instead of reducing the production quotas of its members, OPEC stood idly by. Its historic leader, Saudi Arabia, explained that the higher prices unduly encouraged production of expensive oil, to the detriment of conventional deposits like theirs. By refusing to reduce its production, it maintained prices at a level that prevented North American producers from investing in new projects. OPEC thus regained the market shares it had lost when the price of oil neared three figures.

What price in 2015?

Saudi Arabia has clearly indicated that it did not want to see a barrel at $100 again. The oil from shale and tar sands costs about $75 to produce; below that price, the market is closed to new players.

OPEC’s calculations do not prevent other factors from influencing prices. The current situation is upsetting world economic equilibrium, notably in certain producing countries that do not have the same financial resources as Saudi Arabia. For example, the Russian economy is already badly affected. And then there is always the mood of the stock markets, notoriously capricious.

So where will it all end? Some analysts say that oil has reached its lowest price and that it will rise rapidly to stabilize between now and the end of 2015. But, again, who knows what can happen in the future? One thing’s for sure: the low prices of heating oil and gas at the pump are only temporary, and the bargain could disappear as quickly as it appeared!

————-

*When we talk about the price of oil, we are referring to the usual two crude oil prices followed by economists here, that is, the WTI (American) and Brent (European).