A Look Into Low Cost Oil

by Taylor Beguhn, undergraduate at the University of Iowa

Looking back on the last quarter of 2014 the utter collapse of oil prices has led to instability in several countries, high profits in others, soon-to-be bankrupt companies, and extra presents under the Christmas tree. Over the next several weeks I will walk through the economic consequences a long term low price of oil will have on the consumer, businesses, and countries. However, I would like to start with a simple analysis on why the price of oil has collapsed.

The market for oil, like most goods, can be analyzed with a simple look at supply and demand. Looking at the demand side of the equation we have seen slow to declining global demand from oil due to slow economic growth in Europe, Japan, and several emerging markets. Since the demand for oil is largely understood to be inelastic near .061 in the short run, think basic macroeconomics, typically the main driver for increased demand for oil will be a shifting of the demand curve by a growing or shrinking economy. With demand not rising as much as anticipated the market for oil has seen a supply glut.

The influx of US shale production into the global oil market has destabilized the balance of supply and has directly led to this supply glut. Since 2011 we’ve begun to see US shale production have an effect on the global market for oil as oil prices in Cushing, Oklahoma (the measure for the price of oil produced in the US via shale production) began to deviate from Brent. From 2011 until now, US shale production has not had a tremendous impact on global prices because global demand has remained near global supply. This whole dynamic began to change in August/September as demand growth slowed and supply growth did not. In order to relieve the growing pressure in the oil market one of two things had to give, someone had to give up market share and cut production, or the price of oil would have to drop drastically to equate supply and demand.

In the last week of November OPEC opted for the latter option as they announced that that they would not cut production. OPEC entered this defensive stance to maintain their existing market share and curb future production of oil in the United States by making it unprofitable for companies to further expand production capacity. As soon as the announcement was made, and as subsequent announcements have affirmed the decision, the price of oil collapsed and have been unable to find any semblance of support and/or a price floor, as of the time of this writing. So far, with oil nearing $60 OPEC’s decision has not had the impact originally intended as US oil companies have cut budgets for 2016 and ‘17, not ‘15. Indicating that we will continue to see excess supply in the oil market for considerable time, and no potential bottom for the price of oil, as its highly inelastic sensitivity to price will not support much more demand, even as prices drop. Going forward I expect the price of oil to continue dropping until it reaches $50 a barrel and producers will seriously consider cutting production, or else be forced to produce at a loss. Going forward, I do not expect to see the price of oil rise substantially until global growth stabilizes and demand can once again exceed supply.

Over the next few weeks I will continue to explore the effect a continued low price of oil will have on consumer demand, business, and countries.