The notion that nothing goes down except the laws of gravity is not always true. Prices do goes down when there is a mismatch between demand and supply. As for the Oil industry, the market has witnessed a drastic reduction in its prices in the last seven months or so. The price of Brent crude oil, in June 2014, was around $115 per barrel. On 27 January 2015, it had fallen down to $49 per barrel. The important question, however, is whether the reduction in oil price is translated into lower price level in the economy or not. When oil price goes up, everything rises along with it; but even when prices had fallen by more than half, Indian consumers are yet to enjoy commensurate reductions on fuel bills due to the hike in excise duty on oil by the Union government.The crude oil price hit an all time high of $145 per barrel in July 2008, and analysts during that period were predicting that oil price would soon cross the $200 mark. However, the price went down due to the global recession. By May 2012 crude oil price was around $110 per barrel and the price of petrol in India was around Rs. 73 per liter. The falling oil price send positive vibes to both consumers and producers and expectations were high that domestic fuel price would fall substantially. However, the price of petrol remain as high as Rs. 61 per liter in January 2015 despite the global oil price going down below $50 per barrel.
The volatility in the oil market is a complex issue as numerous factors comes into play for its volatility. In the present scenario, the drastic fall in oil price is attributed to both weak demand and increased supply. On the demand side, there is a significant reduction in demand in major oil consuming economies like China, Japan and European countries due to insipid growth and economic stagnation. Energy efficient vehicles and machineries, and increased substitution of oil by clean and renewable energy have also led to a reduced demand. The supply side is due to increased US domestic production and the OPEC reluctance to reduce output. Citibank analysts have estimated that the world is currently producing around 700,000 barrels a day more than the required demand.
According to the U.S. Energy Information Administration (EIA), which tracks global energy production and consumption statistics, United States produced 14.2 million barrels of oil per day, while Saudi Arabia and Russia produced 11.7 and 10.5 million barrels per day respectively in 2014. Together, these three countries produce more than 40 percent of total global production, which stands at around 75 million barrels per day. On the consumption side, United States consumed 18.5 million barrels of oil per day (mbd), accounting for nearly 20 percent of the world’s total oil consumption per day. This was followed by China at 10.3 mbd, Japan at 4.7 mbd, India at 3.5 mbd and Russia at 3.4 mbd in 2012 (hydrocarbons-technology.com).
The increased oil production in the US is mainly due to hydraulic fracking of Shale oil. Hydraulic fracturing of Shale oil has provided an unexpected source of oil and the US alone has added 4 million extra barrels of crude oil per day to the global market since 2008. This shale oil revolution has redrawn the geopolitical map and fundamentally altered the oil economics. Back in 2005, the US had to import 60 per cent of its oil requirements from abroad, but by 2014, US had to import only 30 percent of its oil requirements. In short, Shale oil revolution has not only increased oil supply but has reduced the demand from the largest consumer of oil in the global market. This has changed the dynamics of demand and supply in the oil market.
The basic rule of economics states that when price falls producers would limit production in order to push the price higher. In the present case, oil-producing countries have not expressed any desire to reduce output despite drastic fall in oil price. The result is partly politics and partly economics. In the 1980s, when oil prices fell, some oil-producing countries tried to cut back on production to prop the price up, but prices kept declining anyway and countries like Saudi Arabia simply lost their market share. The fear of losing market share, in case other oil producing countries did not cut back on production simultaneously, is one key reason why Organisation of Petroleum Exporting Countries (OPEC) decided not to reduce production. OPEC, in its November last meeting, decided to continue producing 30 million barrels a day for the next 6 months.
Analysts also believe that apart from the fear of losing market share, OPEC decision to keep output constant could be to target the Shale oil industry in the US. The shale oil boom in the US was partly fueled by higher oil price. The high oil prices (till June 2014) have made fracking a lucrative business in the US but have negatively affected other oil producing countries as they have to compete in finding market elsewhere, especially Asia. Since hydraulic fracking is more expensive than extracting oil by conventional methods, many believe that oil price below $60 per barrel could hurt the shale oil industries. Thus, OPEC could be intentionally pushing price down to eliminate US competition.
There is also plausibility that the US might be willing to keep the oil price low to penalize and restrict Russia’s ambitions in Ukraine and to pressurize Iran. While US benefits from cheap oil, both Russia and Iran are highly dependent on oil revenue. Russia loses about $2 billion in revenues for every dollar fall in oil price; and with oil and gas accounting for 70 percent of its exports, the phenomenal fall on oil price could mean higher budget cuts and deeper recession. Evidently, the Russian economy has shrink for the first time in five years and Russia’s central bank warned that GDP could fall by as much as 4.8 percent this year if oil prices remain low. To further kill investor’s mood, Standard & Poor’s has downgraded Russia’s credit rating to ‘Junk status’ this January due to Rouble instability and weakening of its financial system.
Other petro states like Venezuela, Iran, Nigeria and Ecuador would be severely affected by the plummeting oil price. Among them, Venezuela is in critical position, as it has to contain both the macroeconomic distortions and the civil unrest arising out of it. Iran is also facing the heat and is probably agitated due to reduced revenues and her inability to convince OPEC to limit output. Saudi Arabia, on the other hand, can sit comfortably and withstand lower prices for years as it had amassed a huge reserve fund of over $ 750 billion. Others would have to sell even more oil, at whatever price, to offset revenue deficits.
As for China and India, there is no better news than cheap oil. China and India spent a whopping $234 billion and $160 billion for oil imports in 2013. Fall in oil price means they will save on their energy bills and spent it on goods and services that can accelerate growth. For every $1 drop in the oil price China saves $2.1 billion annually. That’s more than $100 billion per year for a $50 fall in oil price. As India imports 75 percent of its oil requirements, falling oil prices could reduce its current account deficit by $36 billion from a $40 fall in oil price. Subsidies cost the country more than $40 billion annually. Cheap oil could thus, help government tap additional resources by reducing subsidy bill and finance infrastructure project without stoking inflation. As inflation has stabilized around 5 percent, down from 8.7 percent in January 2014, there is hope that the aam aadmi will also get some relief in terms of cheaper price level.
