The Retrorunning of Oil Prices

From October 2014 up to March 2015 a continuous decrease of oil prices was detected up to a minimum of ~45 $/bbl. This level is very far from the ~95 $/bbl of the end of August/ beginning of September 2014. In April and May a slight recovery has been observed, but even the most optimistic analysts consider very difficult the possibility to have a price higher than ~70 $/bbl at the end of the year. The main question which simply comes to the mind of everybody is the reason behind this sudden collapse in oil prices. There are various hypothesis on the tables and they will be presented in the following.

1- Market Oversupply

Oil_Price

Evolution of Oil Prices

The price of a commodity is given by the interaction of supply and demand, therefore their equilibrium will determine the price. The same should be in the case of oil. At moment, for many analysts, there is an oversupply (excess of production) that the current market level is not able to accept, thus a sharp fall in prices was detected.

The oversupply is supposed to be due to the relevant increase in oil production of USA and Canada, after the discovery of shale oil reserves, which allowed USA, in about six years, to double their oil production. As a consequence, oil from Nigeria and Saudi Arabia, which was directed to the USA, is now available on the international markets, causing the current oversupply condition.

The situation is complicated by the fact that European economies are affected by recession or by very low growth rates, provoking a reduction of their demand. Therefore the trends of the two determinants of price (i.e. demand and supply) move in the direction of a relevant price fall.

2- Issue of Shale Oil

In the last years, USA and Canada discovered the existence of large shale oil reserves in their soil and they started to extract it, enforcing their position on the oil market. In fact, as reported by Bloomberg, in 2014 USA were the largest world oil producer, after overtaking Russia and Saudi Arabia.

Oil_Image_1This fast and relevant growth has caused a reaction in the traditional oil producing countries, headed by Saudi Arabia, which increased their production to cause a decrease of oil prices in order to make unprofitable the extraction of shale oil. In fact, it is commonly agreed that shale oil extraction cost is between 70-80 $/bbl, therefore market prices below this level displace shale oil production.

Of course not all the OPEC countries agree with this position, which penalize some time (e.g. Algeria, Venezuela and Iran), but they were not able to find an internal agreement.

Saudi Arabia claims the success of its oil price strategy, because last April, their production hit the record level of 10.3 Mbbl, whereas in USA there was a slow-down in the extraction of shale oil.

Anyway, it is too soon to derive some conclusion from this side, because the possible dispute is still at the beginning and not many data are available.

Much may also depend on the evolutions from the demand side and on the technological evolution on shale oil extraction techniques, which may cause a relevant decrease of the extraction costs.

3- Geo-Political Issues

According to other point of views the “war” on oil prices could have been an instrument to put pressure on Russia and Iran, in order to soften their position on the disputes with Ukraine and on the plans to develop nuclear power plants

 

The three issues discussed above have a logic and can be realistic, but in my opinion something is missing in the analysis.

In particular, as argued and shown by Carollo in his book, the physical exchange of oil represent only a very small part of the oil market, because, for example, Brent is largely traded for financial aims. The purely financial transactions of the Brent largely exceed the physical ones, so it is not clear how an increase or decrease of the production can alter oil price that much.

Secondly, it is true that the price is set by the interaction of supply and demand, but of what?

Oil is not used “as is”, but its derived products are used in different businesses with different demand evolutions and in order to obtain these products, there is the necessity to have refining capacity. To understand the trend of oil prices, one should look at the market of gasoline, jet fuels, fuel oil, etc. The demands of these products influence the oil prices and the availability of refining capacity, as highlighted also by Carollo.

To have a complete picture of the situation, in my opinion, it is necessary to understand what happened to the volume of financial transactions of Brent, the demand of gasoline and jet fuels (i.e. the high value derivatives) and to the refining capacity, which is supposed to represent a bottleneck of the process (see Carollo).

(c) Vincenzo Bianco

 

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