Oil Prices: What’s Behind the Drop? Simple Economics

By CLIFFORD KRAUSS APRIL 30, 2015

The oil industry, with its history of booms and busts, is in a new downturn.

Earnings are down for companies that have made record profits in recent years, forcing them to decommission rigs and sharply cut investments in exploration and production. More than 100,000 oil workers have lost their jobs, and manufacturing of drilling and production equipment has fallen sharply.

The cause is the plunging price of a barrel of oil, which has been cut roughly in half since last June, reaching levels last seen during the depths of the 2009 recession.

Oil prices have recovered a bit in recent weeks but even optimists say that $70 a barrel by the end of the year is doubtful. Executives think it will be years before oil returns to $90 or $100 a barrel, pretty much the norm over the last decade.

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1. What’s the current price of oil?
   Brent crude, the main international benchmark, was trading around $67 a barrel on Friday.
   The American benchmark was at $60 a barrel.
2. Why has the price of oil been dropping so fast? Why now?
   This a complicated question, but it boils down to the simple economics of supply and demand.
   
   United States domestic production has nearly doubled over the last six years, pushing out oil imports that need to find another home. Saudi, Nigerian and Algerian oil that once was sold in the United States is suddenly competing for Asian markets, and the producers are forced to drop prices. Canadian and Iraqi oil production and exports are rising year after year. Even the Russians, with all their economic problems, manage to keep pumping.
   
   On the demand side, the economies of Europe and developing countries are weakening and vehicles are becoming more energy-efficient. So demand for fuel is lagging a bit.
   
   
3. Who benefits from the price drop?
   Any motorist can tell you that gasoline prices have dropped more than a dollar a gallon in recent months. Diesel, heating oil and natural gas prices have also fallen sharply. Households are likely to spend $750 less on gas this year because of the oil prices, the United States Energy Information Administration said in January. Europeans and consumers around the world will enjoy similar benefits.
   
   The latest drop in energy prices — regular gas nationally now averages a bit over $2.50 a gallon, compared with $3.70 a year ago — is also disproportionately helping lower-income groups, because fuel costs eat up a larger share of their more limited earnings.
   
   Gasoline prices are inching up as refineries do maintenance to switch to more expensive spring and summer gasoline blends.
4. Who loses?
   For starters, oil-producing countries and states. Venezuela, Iran, Nigeria, Ecuador, Brazil and Russia are just a few petrostates that will suffer economic and perhaps even political turbulence. Persian Gulf states are likely to invest less money around the world, and they may cut aid to countries like Egypt.
   
   In the United States, Alaska, North Dakota, Texas, Oklahoma and Louisiana will face economic challenges. Some smaller oil companies that are heavily in debt may go out of business, pressuring some banks that lend to them.
5. What happened to OPEC?
   A central factor in the sharp price drops, analysts say, is the continuing unwillingness of OPEC, a cartel of oil producers, to intervene to stabilize markets that are widely viewed as oversupplied. Prices of OPEC’s benchmark crude oil have fallen about 40 percent since the organization declined to cut production at a late November meeting in Vienna.
   
   Iran, Venezuela and Algeria have been pressing the cartel to cut production to firm up prices, but Saudi Arabia, the United Arab Emirates and other gulf allies are refusing to do so. At the same time, Iraq is actually pumping more.
   
   Saudi officials have said that if they cut production and prices go up, they will lose market share and merely benefit their competitors. They say they are willing to see oil prices go much lower, but some oil analysts think they are merely bluffing.
   
   The death of King Abdullah in January has prompted speculation that Saudi Arabia could shift direction, and there has been some softening in the Saudi public position in recent days. But for the immediate future, most analysts say the Saudi royal family will resist any sharp changes in policy, especially as it tries to navigate multiple foreign policy challenges, like the chaos in neighboring Yemen.
   
   If prices remain low for a year or longer, the newly crowned King Salman may find it difficult to persuade other OPEC members to keep steady against the financial strains. The International Monetary Fund estimates that the revenues of Saudi Arabia and its Persian Gulf allies will slip by $300 billion this year.
6. Is there a conspiracy to bring the price of oil down?
   There are a number of conspiracy theories floating around. Even some oil executives are quietly noting that the Saudis want to hurt Russia and Iran, and so does the United States — motivation enough for the two oil-producing nations to force down prices. Dropping oil prices in the 1980s did help bring down the Soviet Union, after all.
   
   But there is no evidence to support the conspiracy theories, and Saudi Arabia and the United States rarely coordinate smoothly. And the Obama administration is hardly in a position to coordinate the drilling of hundreds of oil companies seeking profits and answering to their shareholders.
7. When are oil prices likely to recover?
   Not anytime soon. Oil production is still increasing in the United States and some other countries.
   
   But production is likely to begin declining in the second half of the year, and then crude prices will also begin to recover in a lasting way. The history of oil is of booms and busts followed by more of the same.