Oil Price Crash

If there’s one resource that makes the modern world go round it’s oil. Pick a major financial crisis or military conflict of the past 60 years and there’s a pretty good chance oil was involved in it somewhere. It’s not just the fuel that drives our cars, trucks, ships, airplanes and a lot of our power stations; it’s also an essential raw material for the plastics and chemical industries. When oil supplies are threatened we see panic buying of fuel, rocketing prices, sometimes even public disorder. Even routine cuts or caps on OPEC output can have a dramatic effect, pushing prices up and placing a brake on the whole economy as everything costs more to power, manufacture and transport. A large part of the USA’s foreign policy since 1945 has been aimed at ensuring a reliable, affordable supply of oil.

But what happens when the usual oil shocks are reversed? What if the market is glutted with cheap oil as supply outstrips demand? Right now we’re finding out. In June a barrel of standard crude cost over $100. The lighter, sweeter Brent and West Texas Intermediate – both in high demand for making gasoline, kerosene and diesel – were selling for more than $125. That was good news for the economies of the Middle East and Russia, the axis of the world energy market. But it also opened up options for the USA. New domestic oil sources like shale have a higher extraction cost than traditional drilling, but at $100 a barrel it was still profitable to extract it. That helped power the boom in production that’s made the USA almost independent of foreign oil for the first time in decades.

Then, in late summer and fall, it started to change. The increase in supply had a downward pressure on prices anyway but not enough to cause any real difficulties. Then a deliberate fall was arranged to hurt the Russian economy; Putin’s budget plans depended on prices of at least $100 a barrel and the break-even point is around $80. With the price dropping through that price in early November Russia has now been losing money for six weeks and struggling since late summer. The idea was to punish Russia for invading Ukraine, but it has potential to backfire.

Usually when oil gets cheap OPEC restricts supply to drive the price back up again. This time they haven’t. Obviously that helps keep Russia poor but the Saudis and their Emirati allies look like they’re aiming more at the USA. The growth of shale oil has threatened their profits, with US demand for imports slumping and the still-recovering economies of Europe and Asia not ready to take up the slack. Now, with prices already low, the Saudis are taking a shot at restoring the balance. Shale oil, with its higher extraction cost, is more vulnerable than Gulf crude; by holding supply up, and prices down, they’re hoping to run the US industry at a loss for long enough that production falls. If they can do that OPEC will regain some of their lost bargaining power – and right now, with the situation in the Middle East, that’s not a good thing.

Ironically, while Russia’s definitely struggling and their economy has shrunk by around 8 percent, they might be better placed to survive. Their actual production costs are among the world’s lowest and that gives them a bit more slack. US shale runs on much smaller margins though, and it’s already making a loss. Higher oil prices bump up costs right across the economy, but right now that might be a price worth paying to ensure energy independence. But with the Saudis now saying they’re prepared to let it fall to $20 a barrel it could be a while before we manage that.