# What is the reasoning behind the sharp fall of oil prices starting in mid 2014?

Things I have considered:

• Poor economic conditions around the world could have caused an unpredicted decrease in demand. The resulting surplus has begun driving prices down.

• This could be exacerbated by a decade of record-high prices that spurred massive investment that changed supply capacity. I know part of this could also be a result of technological innovation that, over the last few years, has changed supply capacity. Add to this the relatively recent discovery of new pockets of oil/natural gas here that producers have begun exploiting.

• Consumer's expect prices to continue falling and so they forgo purchasing fuel if possible. This slowdown in demand can actually help fuel that expected price drop. This could contribute to a steady downward pressure, I think.

• Geopolitical relations between America, Saudi Arabia, Russia and Iran. I know that Saudi Arabia and co. could slash production in an attempt to remove the excess supply and drive prices of oil up again.

• America is now a (the?) leading oil producer world wide and the USA do not import nearly as much oil as it once did. The fact that the USA are using oil extracted and refined domestically has obvious implications etc. An interesting question is how OPEC's recent announcement to not cut production and instead let prices stay low might affect domestic production where things like horizontal drilling and fracking drive up the cost of extraction.

I would really appreciate a substantiated walkthrough of what has caused this very sharp turn around in oil prices. I know the last decade was a time of record highs...so why now the massive landslide in the value of oil?

I should say I am hoping to hear from economists who perhaps have some specialized knowledge here. I do have an undergrad degree in economics and I have read and am familiar with most of the general arguments. I am looking for a well substantiated and thorough answer that will deepen my understanding of this issue.

• see my edit. Happy to provide a few more sources. The key economic behaviour here is that OPEC are maximising the present value of their discounted future profits by exercising their market power. Primarily, their comparably low marginal costs. – Jamzy Jan 13 '15 at 1:15
• Hehe, whatever I have got to say on the subject is going to be migrated to Skeptics.SE anyway. Just a hint: oil markets can be and have been manipulated heavily, even without the Saudis. – Deer Hunter Jan 14 '15 at 14:46
• Deer Hunter - to entirely discredit the possibility that large players manipulate oil markets for geopolitical reasons would be naive, I think. Then notion that nations are interested in the continued downslide of the Russian economy - propped up heavily by Gazprom - seems like one that could be uttered here rather than Skeptics.SE. It might also be that I belong there with you lol. – 123 Jan 14 '15 at 15:13
• Here's why the price of oil is dropping so fast economictimes.indiatimes.com/markets/commodities/… – Vibhas Kulkarni Jan 15 '15 at 7:03
• Why are people suddenly down voting this question? – 123 Jan 20 '15 at 5:28

My understanding of the recent drop in oil price is due to recent changes in US drilling. They are now the worlds largest oil producer. This article by the economist does a good job explaining.

My answer (borrowed very heavily from the economist.)

• Demand is low because of weak economic activity, increased efficiency, and a growing switch away from oil to other fuels.

• America has become the world’s largest oil producer, creating a lot of spare supply.

• The Saudis and their Gulf allies have decided not to sacrifice their own market share to restore the price. They could curb production sharply, but the main benefits would go to countries they detest such as Iran and Russia. Saudi Arabia can tolerate lower oil prices quite easily. It has \$900 billion in reserves. Its own oil costs very little (around$5-6 per barrel) to get out of the ground.

For further reading, the NY times has a decent article explaining it a little more.

edit: I think it is safe to assume that OPEC has market power. They can get oil far cheaper than their competitors (as referenced above).

With that in mind, The below reference provides a model which explains what we are experiencing here. Cournot competition seems a perfect model to use.

• Naoum-Sawaya, J. and Elhedhli, S. (2010). Controlled predatory pricing in a multiperiod Stackelberg game: an MPEC approach. J Glob Optim, 50(2), pp.345-362.

A key quote from the above article: "After reducing or eliminating competition, the predatory firm can raise its price and compensate the loss by earning monopoly profits in the long run".

This second provides a very brief overview of OPEC and their behaviour.

• OPEC reflects on its history. Salisbury, Peter, Middle East Economic Digest.

I couldn't find an empirical study comparing a Stackleberg model to the OPEC cartel but I do not doubt that this has been done to death.

• I can't find this article anywhere online for free. Most sites charge about 25 dollars to download the paper. Do you happen to know a free source? Or did you only read the abstract? I am curious - since all infrastructure exists and since firms here have invested so heavily in knowledge and technology - if OPEC's predatory strategy would yield typical results (firms stay out of mkt once prices rise again) or if American firms will re-enter the market and produce once prices become high such that domestic production is again profitable. – 123 Jan 13 '15 at 15:31
• I should add - nice reference. I am very interested to read the paper. – 123 Jan 13 '15 at 15:34
• It is an interesting paper. I personally wouldn't get \$25 of joy from it though. – Jamzy Jan 13 '15 at 21:56
• The results basically are, when there is market power, it is possible to eliminate competition and increase equilibrium prices. there doesn't seem to be a file send or PM feature on this site. – Jamzy Jan 13 '15 at 22:17
• This never received the level of detail I desired. Nevertheless, yours was the best answer and bounty's are nonrefundable and are auto-awarded. I wanted to at least ensure the best standing answer received the bounty. So thanks for what you have provided, Jamzy! I still want to read that paper. – 123 Jan 23 '15 at 13:45

I'll go ahead and admit that I do not have any empirical evidence, and this is more of factor to consider when evaluating future movement in the oil market.

As oil prices drop, some US oil producers will find continued exploration and production unprofitable. This will serve as a counter balance to the falling prices aa producers choose to reign in supply.

It remains to be seen if this relative decrease in supply will prove sufficient to cause any significant increase in market prices.

• I already addressed something like this in the last of the bullet points. I agree, the OPEC cartel could be successful with the predatory strategy. However, I wonder if they aren't doing anything other than establishing a floor for the mkt. Anytime OPEC pushes prices high such that domestic extraction becomes profitable supply will increase accordingly and place downward pressure on oil prices. – 123 Jan 13 '15 at 0:41

The basic factors in the decline of petroleum prices is the increased production in the US in the North Dakota and Texas shale oil fields as a result of the use of hydraulic fracturing in conjunction with horizontal drilling (up to 2 miles horizontal in a single borehole. Furthermore, the Saudi Petroleum Minister chose not to reduce their output in order to bolster international prices. The International Energy Agency is forecasting the US to remain the largest petroleum producer through 2020, though the Saudi's could easily increase their production if they choose to do so. Even though we are the number one producer, we are also the number one consumer of petroleum, importing 7.5 million barrels of crude per day in 2014.

The US did become the number one petroleum producer in 2014. Prior to that Saudia Arabia and Russia ranked ahead of the US.

Considering oil as a commodity that does not expire and can be relatively easily stored, I believe the reason for the recent price drop of oil is much more political than what it has to do with economics. Russia is a giant producer of crude oil and its governmental operation fund is tightly related the export tax of oil. By lowering the price of oil, the world is effectively putting pressure on Russia and perhaps it's a punishment for invading Ukraine.

• This is something I have considered and discussed under the geopolitical musings bullet in the question. I am glad other people agree...I feel much less conspiratorial. – 123 Jan 14 '15 at 23:39

I really like Jamzy's explanation and believe I am not offering any new points but would like to offer additional detail.

Demand

We see that other than in North America, economies all over the world are in a bit of a slump. Growth rate is low in Europe due to the Eurozone crisis. China's growth rate has steadily declined this decade due to a decrease in worker productivity which in turn is attributed to investments in infrastructure and real estate not having the same effect as in the past. The fall in metal ore prices has led to decreased growth on ore exporting countries like Chile and Brazil. This means aggregate demand for countries all over the world is not increasing as fast as expected. AD low (for various reasons in various countries) -> less need for inputs into economy -> drop in demand in global petroleum market -> drop in price

Also, we have vehicles becoming increasingly efficient and a transition away from oil across the globe. See this chart (http://www.c2es.org/docUploads/PV-fuel-economy-standards.jpg) which shows dramatic increases in vehicular fuel efficiency in recent years.

Lastly, we have countries trying to diversify their energy sources, either to reduce exposing their economies to geopolitical risk (e.g. China) or to protect the environment (e.g. Europe).

Supply

Libya and Iraq - Libyan oil production recovered in September and Iraq's production was not affected by unrest, contrary to expectations.

OPEC's Statement OPEC made a decision in November 2014 to maintain collective oil production at 30M b/d despite a glut in supply due to all the other factors mentioned. The intention here is pretty clear: to put American Shale and other unconventional sources of petroleum out of business. By producing extracting petrol at low prices, they force any method of production with higher costs to shutdown either temporarily or for good, depending on how long they can maintain 30M b/d. See (https://imfdirect.files.wordpress.com/2014/12/oil-4.jpg) for the cost curves.

On a side note, the economics of oil storage are interesting as well. Oil traders are currently keeping full oil tankers offshore due to unprofitable prices (and also because these tankers would not be needed to bring oil anywhere anyway due to lackluster demand). On the other hand, we have strategic petroleum reserves which (in the case of the US) are difficult to get oil OUT of (~45 days to fill 5M barrels from storage), leading to people arguing that the US govt should not bother refilling them.