Oil Prices

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Approx. 2min31sec reading time

Oil prices have been dominating the news lately, they have fallen ~46% in 2014 (WTI Crude $115 in June to $55.62 today). This blog post will look into why oil prices have fallen, why OPEC hasn’t decreased production to boost prices and what is expected to happen as a result of the price drop.

Note: WTI vs. Brent. WTI stands for West Texas Intermediate and represents the American market. Brent Crude oil is more representative of North Sea oil and the European market, it is slightly more expensive than WTI.

Why have prices dropped?
Whilst reading through these main reasons the concept of supply and demand should be in your mind, as it is the main causation for movements in oil prices and links to all these reasons.
Reduced global demand. The world economy is slowing and demanding less oil. Less demand, combined with significant increases in supply (shale), leads to a lower price.
Conflicts in Libya and Iraq have not affected supply of oil as much as the market predicted they would. As supply has remained constant in the Middle East the markets have adjusted their pricing downwards.
Saudi Arabia (and therefore OPEC) has decided to maintain oil production at the same level throughout the price drop. Usually OPEC reins in supply to boost the price during drops.

Whilst prices have dropped substantially this year, it can be noted that it is not unusual for Oil to take large dips. This is demonstrated in the graph below.

Last major price fall was following the 2008 financial crisis
Last major price fall was following the 2008 financial crisis

Budding technical analysts will notice some prominent head and shoulders in 2006, 2009-2010 and 2013.

Saudi Arabia
Reason three is one of the more interesting causes of the price fall, as it is assumed that large oil producing countries such as Saudi Arabia will want to maintain a high price.However SA hasn’t taken that stance this time round.

There are two theories as to why Saudi Arabia (SA) has decided not to decrease production:

One, reducing supply will only see their production being substituted elsewhere. For example Kurdistan just entered the market with 600,000 barrels a day, and on top of that the USA have the largest oil reserves for 38 years thanks to the fracking movement. If Saudi Arabia reduce production they will have other countries ‘take their market’.

Two, Saudi Arabia might be taking a political stance against the shale movement. Their break-even point for oil production is between $5-6 a barrel, meaning the price can plummet and they will still be in the black. However the break-even point for most shale gas companies in America is between $40-80 a barrel. By maintaining supply and pricing shale out of the market SA can then pick up new contracts and benefit from the price rise. SA are already assuming a $80 barrel price in their budget next year.

What happens next?
Oil prices should be good for global economic growth, as oil is a necessity for most areas of production. However the fall in oil prices is also a signal that economic growth is weak, almost $1.3trillion has been wiped off the global stock markets this month alone, as a result of poor market sentiment. I think the drop in oil prices is an indicator that we can expect a sluggish 2015, with mediocre economic growth and not a great stock market performance.

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