Credit: naecnigera.org.
by Rich Chi
April 3rd, 2015
An analysis of the forces that drove oil prices down and a prediction on how long prices will remain cheap.
To understand why gas prices are so low today, we first need to examine what led to its record low prices in December 2014. From the summer of 2014 to January 2015, oil prices have fallen more than half, from $110 a barrel to $50 a barrel. What caused the sudden shift?
Throughout the 2000s, OPEC-controlled oil supplies did not keep up with the world’s increasing demand led by China’s rapid industrialization. This resulted in a steady increase in oil prices peaking in 2008 at $140 a barrel. Since then, an increasing number of US oil producers began to drill into harder-to-extract forms of energy in the form of shale. This method of production is far more expensive than traditional forms of extraction used by producers internationally (Figure 1). However, high oil prices made shale extraction profitable.
Then why did gas suddenly become so cheap?
In 2014, US oil expanded the most since 1900. The additional oil supply from increasing number of shale producers combined with the slowing demand for oil in Europe and Asia due to factors such as decreased infrastructure investment and increased fuel efficiency technology created the price crash seen in December 2014. In the wake of sudden shifts in the international supply and demand of oil, OPEC, led by Middle Eastern oil producers, has refused to cut production to preserve higher oil prices. This decision makes sense because while cutting production may increase oil prices, it also decreases OPEC’s market influence, negatively impacting its international political and economic influence. Therefore, OPEC would rather decrease its bottom line in the short running while still maintaining profitability over its competitors at cheap production costs. Although Middle Eastern oil producers are expected to face the largest blow facing lower oil prices, their production operations are still far more profitable than that of the US. At prices lower than $70 a barrel US producers with production costs up to $75 a barrel cannot compete with OPEC producers with production costs as low as $20 a barrel.
OPEC hopes that lower oil prices will eventually shove out oil producers (such as those from the US and Russia) with higher costs while increasing the demand for cheap energy. Over time, oil supply outside the OPEC will decrease and prices will increase in the wake of higher demand for OPEC oil; this will allows them to maintain their market presence while sustaining their bottom line. At $50 a barrel as of April 1st, 2015 the extraction operation for North American shale producers is far less than profitable. However, the rate of US oil production is still expected to increase this year.
So if OPEC refuses to cut oil production and US oil production is increasing, why aren’t gas prices even lower?
Then why is oil production increasing when crude oil prices are so low that many US oil production operations are no longer profitable?
Demand:
Americans love cheap gas! The shift in demand is partially due to consumers drifting away from thrifty habits such as carpooling as observed over long periods of high oil prices. As oil consumption increases due to oversupply and low prices, it contributes to stabilizing how steep oil prices have dropped and helps US producers to maintain profitability in their shale extraction projects.
Time Lag:
A new oil rig drilling project can take years to complete construction and start producing oil. Because the price crash was swift and unexpected, Oil producers cannot shift their production schedule in such a small time frame. Despite soaring oil demands due to lower prices, US oil inventories are building up quickly. Barclays energy analysts expect production to decrease and stabilize within the second and third quarters of this year.
Sunk Cost:
New oil wells require financial and human resource commitments up front years before becoming profitable. Because US oil producers invested heavily into new oil extraction projects before the price crash, these investments are considered to be sunk cost in the wake of lower oil prices. It does not make financial sense to shut down oil wells that have already been drilled and reduce its production after already committing financial investments although lower oil prices have affected its projected profitability. Investments into new drilling projects, however, are expected to decrease, helping to raise and stabilize oil prices.
What does this mean for you, the consumer?
Increasing gas efficiency and the slowdown of China’s industrialization have resulted in a worldwide decrease in the demand for gas while gas supplies are not expected to dramatically decrease over the next decade, in accordance to OPEC’s announcement that they will not cut production. While oil prices are expected to recover over Q2 and the remainder of 2015, it is not likely to reach its peak price in 2008 at $140 per barrel. However, the US and other oil producers abroad with similar extraction costs per barrel will struggle to maintain profitability and eventually decrease production. That’s right, gas prices are going back up. OPEC projects that the price of oil will stabilize at $110 per barrel for the remainder of the decade. So enjoy your cheap gas now, it won’t last for long!
Rich Chi is a contributor at the Economics Review at NYU. He’s a finance major at the Wharton School of Business at the University of Pennsylvania. He can be reached at rickc@wharton.upenn.edu
References
The Economics Review 