Low Oil Prices and the Global Economy: Why OPEC’s Lifeblood has dried up

Over the last month, global crude oil prices have frequently been dropping below $30 per barrel, a drop from $120 per barrel in 2014. Cheap oil is a boon for many Western countries but ravages oil exporters who depend heavily on its revenues. How did this low oil price come about, and will it last?

NEXT POST: Windmills and Tar Pits: The Effects of Low Oil Prices on the Environment

For decades, oil has been playing an essential role in the world economy. It powers our cars, lights our homes and many of the products we consume, such as plastics, are based on oil. It is deemed so important that countries such as Britain and the United States have on multiple occasions intervened militarily to secure its supply, occupying oil fields near Mosul and staving off an Iraqi invasion of Kuwait.[1]

For decades, its price was controlled by the Organisation of Petroleum Exporting Countries, commonly known as OPEC. Whenever prices were threatening to go down, the consortium would collectively cut production to keep prices stable. It was a win-win at the time, with OPEC getting rich off its oil proceeds, and the Western world experiencing a secure supply of its coveted resource.

However, near the end of 2014, the world saw oil prices dropping. At first, OPEC was not too concerned, but when oil prices started to break $60 they got a little worried. Little did they know that prices would go down even further, going as low as $30 per barrel at the end of 2015. These oil countries, who got used to excessive spending under high oil prices, are now running massive budget deficits.[2] Their good fortunes seem to have run out.

Historically, OPEC would just cut production and prices would return to ‘healthy’ levels. But this does not seem to work anymore. Now countries such as Venezuela, 97% of whose exports consist of oil, [3] are experiencing social unrest. Even bastions of economic stability such as Saudi Arabia are struggling with public discontent about the current situation.[4] To explain how this all happened, we need to look at three different developments, which together resulted in the current crisis.

The first reason that oil prices – and commodity prices in general – are suffering is because of the recent struggles in the Chinese economy. As the world’s primary manufacturer, it plays an important role in the demand for raw natural resources. Oil companies around the world gambled on China and opened new oil wells, severely increasing the supply of oil on the market. But now that demand isn’t as robust as producers had imagined, suddenly there is a large surplus of oil – i.e. the prices are going down rapidly.

The second important development that led to the low oil prices is the emergence of oil production in the United States. Although it always had its own oil fields in Texas, it recently expanded its oil production as a result of new technological developments. Through hydraulic fracking, oil companies were able to produce oil which was previously not producible. This ‘shale revolution’ flooded the market with new oil, bringing prices down. But it had another important effect.

The United States, historically an importer of oil, was not a member of OPEC, and therefore did not participate in the coordinated production cutbacks which would drive the price back up. This reduced the ability of OPEC to dictate prices because any production decrease within countries such as Saudi Arabia or Algeria would be matched by a production increase in the United States. It didn’t help that many OPEC countries were reluctant to cut production since their budgets depend so heavily on oil. Compounded by the fact that many OPEC countries were already cheating – exceeding their oil production ceilings for some additional income – OPEC’s traditional response was deemed largely ineffective.

Therefore, OPEC decided to resort to a different tactic. Rather than controlling supply to increase prices, it is now massively expanding its own oil production to drive prices even lower, and hopefully, drive American shale oil producers out of business. However, US shale oil producers have proved to be more resilient than many anticipated: In 2015, US oil production increased despite oil prices hovering around $50 a barrel. And even now, with oil prices at $30 and lower, a decline in production has only just set in.[5] Arguably, it has only created more problems for some OPEC countries such as Nigeria and Angola, whose break-even prices for oil are much higher than for instance Saudi Arabia.

Whether these low oil prices will last is still heavily discussed. Some analysts expect low oil prices to persist in the short term. Part of this is due to the lingering oversupply,[6] but another contributing factor is the lifting of sanctions on Iran, which allows another major oil producer to enter the global economy.[7] However, there are also those who predict a strong price increase in the long term, because declining US production and investments which are cut back now will lead to shortages in the next few years.[8] Until that happens, the world will continue to burn cheap oil for its development and growing consumption. Whether we like it or not.

Update 15-6-2016: Brent crude prices have recently risen to $50 per barrel as a result of supply disruptions in Libya, Venezuela, Nigeria, Canada and reduced shale production in the United States.[1] EIA forecasts prices to stabilize around this price point, still well below average prices over the last five years.[2] As such, the conclusions of the article still stand.

As of July 2016, the world has experienced a solid two years of low oil prices. For some, it is easy to see what the effects have been. Companies, such as BP and ExxonMobil, have been forced to lay off thousands of workers and saw their earnings go down dramatically as their main source of income fell away. [1] For the rest of the world, evaluating the effects is a bit more difficult.

Even the best academics, commodity analysts and international organizations sometimes struggle to predict the effects of low oil prices, which is unsurprising: Oil prices by themselves are notoriously difficult to forecast,[2] and even then it matters greatly whether the change was caused by increasing supply or demand. [3]

Traditionally, high oil prices were seen as a good situation for sustainable development. Especially when oil still traded at above $100 a barrel, it was certainly attractive to invest into new technologies, and many investors poured into the market for alternatives. Before the collapse of the oil price in 2014,[4] investments in renewables were growing by double-digit percentages nearly every year.[5] At the same time, high oil prices do not only lead to investment in sustainable technologies, but also in new oil extraction methods, such as hydraulic fracking and tar sands, particularly in the United States.[6] These new forms of oil then drive down the price to meet the rise in demand: High prices kill high prices because human ingenuity finds a way to produce more in times of scarcity, in order to turn an even greater profit from oil.

Environmentalists used to be very scared of the prospect of a prolonged period of low oil prices. After all, basic economics suggest us that when the price of a good goes down, its demand will go up. And when consumers become more wasteful with their energy because of an abundance of oil, that cannot be good for our emissions reductions – so it is thought. They are not entirely wrong: When the oil price collapsed in early 2015, demand surged in the months directly afterwards. But what is remarkable is that for the rest of 2015, demand actually fell[7] despite oil prices hovering around $30 per barrel. In other words: When it comes to oil prices and sustainable development, there is more at work.

One of the benefits of low oil prices for the environment is that it becomes uneconomical for companies to extract oil from a variety of sources. For instance, in 2015 Shell got rid of all its extraction facilities in the Arctic, after the collapse of the oil price made the endeavour unprofitable.[8] This is not an isolated incident: Oil is being kept in de ground in other places as well, because it is just not profitable to extract it.[9] And oil that is kept in the ground cannot pollute the atmosphere.

So what is the net effect of the low oil prices for the environment? That is still hard to call. However, maybe we are asking the wrong questions: Perhaps low oil prices are an output of sustainable development, rather than an input for it. What if they are the result of a structural transformation of our economy?

First, it is important to understand the basics of how renewables affect oil prices. Oil is used for many purposes, including for industrial petrochemicals, transport, and power generation. Competition between renewables and fossil fuels occurs mostly in the latter, not because we burn oil in our power plants (we hardly do)[10] but because of natural gas. Oil and gas prices are closely related due to their substitutability,[11] which means that reduced demand for natural gas puts significant downward pressures on global oil prices.

Therefore, the arrival of new, cheap alternatives can be seen as disastrous for oil producers. As renewable prices are falling, they approach the energy costs per MWh of natural gas-fired power plants.[12] Renewables are already equally or less expensive than the newest and most efficient fossil fuel technologies in some circumstances, and this trend is not likely to stop. In fact, 2015 marked a record year for renewable energy sources, with 147 Gigawatts being added in the power sector alone.[13] To put that into perspective: Renewable energy added more capacity than all other forms of power generation combined.[14]

This contribution of cost-effective alternatives is an important and often overlooked part of oil prices. When new capacity is generated by renewables, rather than fossil fuels as the market expected, demand for the latter drops and prices take a dive. That would explain why, despite unprecedentedly low oil prices, renewables are still going strong.[15]

Of course, this effect must not be overstated: Oversupply and slowdown of the world economy are still incredibly important for the price of oil. But oversupply can be tackled by organized production cutbacks, and demand for oil is likely to increase again when the global economy rebounds. Falling renewables prices, on the other hand, are not so easily subject to a reversal of fortune.

There are still many challenges for renewable generation, particularly in the transport sector, which means that oil will not be obsolete for decades to come. But it is encouraging to see that technological advancements are exceeding everyone’s expectations. Perhaps the environment is not completely damned after all.

Pim ten Haaf is a graduate student at Wageningen University and Research Centre. With a background in forestry and climate change, he writes about the role of energy, forests and agriculture in climate change and the global economy. Before becoming a writer at Viissi, he interned at the Hague Centre for Strategic Studies and Chatham House where he wrote on energy security, agricultural commodities and climate change.

Original Article found at viissi.com 

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