Why Are Oil Prices Falling?

Oil prices are now around $80 per barrel, their lowest in four years. Prices used to be around $110 up until summer, when there was a sudden plunge. With problems in Iraq, Libya, Syria and Nigeria, prices should be increasing, not decreasing. So what’s going on?

The global economy is weak. Japan’s GDP fell for a second consecutive quarter, and Germany, the engine of Europe, seems to be heading toward a recession. China is facing an uphill battle to maintain its anticipated growth, and the U.S. is growing, albeit slowly, in comparison to its historical standards. The IMF has lowered its 2014 global economic growth projections for a third time, reducing it to 3.3 percent.

However, a low level of demand cannot justify such a drastic drop in prices – 15 percent in three months – especially in moments of instability for relevant producers. Thus, the answer should essentially be found in the output factor: last year’s production rate is currently being exceeded by over 2.8 million barrels per day. The U.S. and Saudi Arabia may be mainly responsible for this.

The U.S. situation seems to be more transparent: a 65 percent increase in its oil production in just five years as a result of the shale revolution, raising its output rate to 8.8 million barrels per day, its highest level in almost 30 years. In pursuit of private interests, Saudi Arabia opens its oil floodgates, increasing production output to almost 10 million barrels per day.

What is the latter country seeking? In strictly commercial terms, a larger market share or more precisely, a larger share in the Asian market which accounts for 75 percent of global demand growth. With its low-cost production and flexibility for production increase, Saudi Arabia can steal clients from many of its OPEC partners. Its intentions are so apparent that apart from forcing prices down, it reduced its barrel price by a dollar for Asian countries. According to analysts, the Saudi monarchy also seeks to make U.S. shale oil less profitable, but this is a baseless argument. Around 80 percent of shale oil production would only become unprofitable when one barrel costs $60.

Nevertheless, it would be naive to not assume that there is also a political objective behind the commercial one. Let’s not forget that Saudi Arabia is the head of the Sunni bloc, which rivals the Shiite bloc led by Iran, and that both countries have indirectly come face to face in Syria. When Tehran began its recovery through sanction flexibility, along came this new blow. Slipping from number eight in the list of top OPEC producers (due to sanctions), Iran has successfully endured these penalties through high prices. The drop in prices is consequently devastating.

If we take our suspicions to the level of political realism, we must presume that Saudi Arabia is not alone in this attempt to lower prices for geopolitical reasons. Just as Riyadh is interested in outflanking Tehran, Washington wishes to do the same with Moscow. In fact, in recent days, the New York Times’ star columnist, Thomas Friedman, wondered whether the U.S.’ and Saudi Arabia’s outstretched hands could possibly be behind the drop in prices. Nothing would make more strategic sense to both countries.

In 1985, the fall in oil prices unleashed an economic crisis in the USSR and set in motion the dynamics which led to its implosion. Conversely, it was the sustained increase in oil prices that gave Moscow back a part of its lost influence. If Moscow has to endure a reduction in its economy’s vital intelligence in addition to the sanctions imposed by the West, the impact will be tremendous.

If this is the reality, it is worth wondering how long Washington and Riyadh can maintain current price levels. Given that Saudi Arabia’s production costs total $6 per barrel, this may be deemed to last forever. But this is not the case. Maintaining the kingdom’s political and social stability requires massive social expenses and costly infrastructure projects. In order to keep the ball rolling, it will have to tap into international reserves, that is, $750 billion, to go a long way. However, nobody wants to eat up their reserves. U.S. shale oil production costs are substantially higher than those of Saudi Arabia, though still below current prices. These are some of the advantages and disadvantages for this country. On one hand, its economy has now become dynamic, but on the other hand, there is much ambivalence regarding one of its key economic sectors: shale. This undoubtedly discourages investment.

By all accounts, prices will remain down for a while.