Control over Oil Prices

I have been greatly enjoying the consumer benefits of a global oversupply of oil, as gas prices have nearly been cut in half here in Cedar City. I admit that I have been somewhat ignorant to the root cause of falling oil prices. I hear commentaries from co-workers and classmates about the oversupply, but I have not taken much time to dig into it myself. I have come to the simple understanding that global oil supply is significantly higher than global demand.

This article helped be to gain a more complete understanding of an issue that affects each one of us. The main misconception that I had was that if oil supply was too high, the major suppliers would simply cut back in order to keep prices at a healthy level. There is certainly some scaling back going on, but the world’s largest oil cartel, OPEC, decided toward the end of 2014 that they were unwilling to risk their market share to raise prices.  Saudi Arabia, the world’s second largest supplier, took a similar stance. So, supply continued to exceed demand and prices fell to the lowest we have seen in years.

The most interesting lesson that I learned from this article is that even the largest oil suppliers in the world cannot control the market perfectly. With everything that we know about growth trends and demand and demand around the world, there is still much uncertainty involving this industry. The textbook describes the influences that market forces have on the supply/demand curves. In theory, it seems quite simple to forecast changes in these curves and make adjustments to reach market equilibrium. However, we are witnessing a real life example of how difficult it can be to reach such equilibrium.


Dave Tufte said...

EC: 100/100

Here we go again folks. Let me help you: stop saying that demand or supply is higher. The only way a line/curve can be higher is if they don't intersect. Exceed isn't really a good description either.

For that matter, stop writing increased or decreased for supply and demand too. Those adjectives apply to numbers, not to lines/curves.

There's one little trip up in EC's current events. OPEC and Saudi Arabia really aren't separable. Saudi Arabia is the dominant country in OPEC, had been for 50 years, and it's been decades since another country even seriously challenged their policy choices.

I've been unofficially "deputized" as many peoples' expert on oil prices for southern Utah. That's what I get for being a macroeconomist, right? Anyway, you'd be surprised the extent to which no one understands why oil prices move the way they do. Here's what we do know.

There has been some leftward shift in global demand. Mostly this is coming from China, whose economy has been on the weak side for a while.

But, that can't explain the huge price drop we've seen.

Another factor is the huge shift to the right of supply due to increased U.S. production, mostly from horizontal drilling in shale formations in Texas and North Dakota. The thing is, that oil can't be exported. However, that means our demand is more likely to be satisfied with domestic production, and contributes to the leftward shift of global demand.

But again, that can't explain the whole thing. Let's think about supply.

The thing is with oil, it doesn't really depreciate when stored. What's even more interesting is that it can be stored below the ground (by not being pumped up), or in storage tanks on the surface. It has value in both locations, but it isn't liquid value (in the monetary sense of liquidity). To make it liquid, you have to sell it. To clarify: there must be a lot of suppliers who are not content to have their wealth in a less liquid form, but who are instead converting it into cash income.

Who needs cash? Russia and Iran are at the top of everyone's list. The guess is that the governments of these countries are so strapped for cash flows that when the price of oil drops they have been selling their oil even more desperately, driving the price even lower.

Lacey said...

Dr. Tufte, I'm glad you mentioned Russia in your comment on the current situation with oil. A few months ago I read an article in The Economist that suggests the current oil prices are intentionally being kept lower than what is achievable by Saudi Arabia in an effort to financially 'cripple' Russia and Iran. We've discussed price floors and ceilings in class already on the national level but it is interesting to see a somewhat similar concept at the global level being used as a way to financially weaken corrupt governments. I'd like to know your thoughts on whether this kind of political manipulation is ultimately beneficial or detrimental to the world economy. I realize this isn't quite the same as a price ceiling, and that there are multiple moving parts to the situation but I wonder how the world economy would look if ultimately the Russian government were to go entirely bankrupt along with the Assad regime in Syria (currently funded by Iran). Is it possible for this short run sacrifice to turn into a long run success economically speaking or are we strictly sacrificing economics for political gain?

Dave Tufte said...

Lacey: 50/50.

I think Saudi Arabia might have an interest in crippling Iran. I'm not sure they care that much about Russia.

Even so, it begs the question "Why now?". I don't think there's a good answer to that one.

For their part, the Saudis have said that they won't cut their production to maintain high prices, but not that they'd increase production to lower prices.

So I still think the primary cause is someone selling into the price drop. What I find most believable is that there's downward pressure on prices from global demand and U.S. production, which has put a revenue crunch on Iran and Russia, who've responded by undercutting other sellers to maintain their cash flows.

Personally, I find the Saudis to be more geopolitically dependable and progressive than the Iranians or the Russians. So I'm glad that this is happening.

But, as an economist, I know the public puts way too much stock in the ability of sellers to "ruin" other sellers by undercutting their prices. There just isn't a lot of evidence that such predatory pricing actually is successful. So I don't think there's some big plan being put on to bother Russia and Iran. Are a lot of people happy that they're being bothered? Yes. Are they doing it on purpose? Probably not.


If I can extend this a bit into macroeconomics, I tell my students that they can go far by recognizing that 1) government attracts people with control issues, and 2) a lot of governments act like they're run by boys who stopped maturing as teenagers. Through that lens it makes a lot of sense to view the Russians and Iranians as capable of making the wrong choice (actively trying to sell more) when faced with falling prices. On the other hand, say what you will about Saudi society, but at the top that country is run very professionally. You could say the same thing about American oil companies. Both of those groups are low cost producers of oil who know better than to panic, and both are flush with cash. I can see them acting passively and laughing all the way to the bank.

Pedro said...

I am also ignorant to the cause of the price drop in oil but have been very happy every time I have to go to the pump. The comments about OPEC have been interesting so it led me to do more research about them. Basically they are a group that produces about a third of the oil used in the world and have a heavy influence in the production of oil.

I also came across an article that is talking about the gains the OPEC is expecting to have this year. Now that oil prices are low and we are all buying more they are gearing up to produce even more. The forecast for the higher production is to the tune of 140,000 barrels per day. While where the oil is getting used most is still not unclear the price has also had a positive affect on the amount of SUV's and large vehicles bought in recent months.

Another point that I have heard on this issue is that OPEC is the most prepared for the increase in demand that is going to happen. While some areas of oil producing have slowed down due to the falling prices they have not skipped a beat and are ready to supply oil to any country that is in need in the near future.

Dave Tufte said...

Pedro: 44/50 ("While where the oil is getting used most is still not unclear..." isn't clear at all, you mean "areas of oil production" not "areas of oil producing")

The economics in the comment is pretty muddled. There's an aphorism in economics: "don't reason from a price change". It means that your explanation has to start with why the price changed, not that it changed. Pedro may have lifted this straight from the article — this sort of thinking is pretty common.

My comments above are that there definitely has been a leftward shift in demand (but not large enough to explain the big price drop) without some rightward shift in supply (we just can't pin down who's doing that). The thing is, the slope of demand already captures consumers' interest in buying stuff like new gas guzzlers. But a production increase like that described is an additional supply shift that will drop prices even further.

The mistake is repeated in the next paragraph. Any effect that the lower price had to reduce production is already in the slope of the supply curve.

So I kinda' wonder about the whole comment. It's good to think about this sort of stuff, but it's a craft we all have to work at.

Ted said...

First I would like to say how glad I am to find one of my classmates had written about Oil supply / prices and the global market. I have recently been interviewing with Goldman Sachs and one of their interview questions was about this topic. Needless to say, I am glad to learn more about this.

Effects of OPEC and Saudi Arabia not lowering production to increase the price of oil are not only limited to crippling or hurting the economies of Russia, Venezuela, or Iran. The effects are also felt here in the U.S.

While most of the country is benefiting from the lower prices in oil which allows them to purchase other products that are produced locally (thereby helping local economies), other states are feeling the negative impacts. Texas and North Dakota for example are experiencing a decline in oil production of over 15% since December. If oil prices continue to stay low, the long term effects of low oil prices in the US will hurt these sates that have been producing oil. This hurt will come in the form of lost jobs. According to Dallasnews.com, in 2014 Texas added over 441,000 jobs relating to oil production. These jobs are at risk if the US oil companies can't compete with OPEC and Saudi Arabia's cheap oil. This will impact the state economies as less tax dollars are collected, and also affect the housing market when people cant meet their monthly house payments causing them to move.

Granted I don't think this will be detrimental by any means to the US economy as a whole, but there is a real chance for thousands of US citizens to lose their jobs. This shows its not sunshine and happiness for everyone in the US when it comes to lower gas prices.

Dave Tufte said...

Ted: 38/50 (miscapitalization of oil, "sates" instead of "states", you mean "can't" not "cant", and "it's" not "its", and I'm letting you slide on whether "state economies" is supposed to show agreement with the singular Texas).

OPEC is an organization that includes Saudi Arabia. So saying OPEC and Saudi Arabia is redundant.

Also, OPEC includes Iran and Venezuela, so I tend to doubt that OPEC is doing anything to hurt them specifically.

It is in the interest of Saudi Arabia to reduce Iranian cash flows. But Saudi Arabia probably doesn't have much interest in Venezuela or Russia.

OPEC is dominated by Saudi Arabia, but isn't a very functional organization. As a group, OPEC was unable to agree on lowering production to shift supply to the left. The Saudi Arabians have indicated that they don't see a need to reduce their production, but by all accounts haven't gone out of there way to increase it either. The price drop works to their advantage (since they are a lower cost producer than most), and they're just not discouraging it.

I think Ted is right about Texas. That "economic miracle" they're having isn't going to look very good if oil prices stay low.

EC said...

The comments since I first wrote this post have been quite insightful and I appreciate all of them. Lacey, I'm glad you brought up financial condition of Russia and how this affects the industry. It was interesting to look into this issue a bit more. This article in The Economist was helpful in understanding more about what is going on in Russia.

Going back to something that I mentioned in the initial post, I think it is interesting to note that an optimal market equilibrium is often not reached because players in the industry have differing priorities. In this case, Russia is not as concerned about reaching an optimal level of profits. Rather, they are in dire need of cash and that need appears to trump any other. It is interesting that one player with differing interests can have a significant effect on the global industry.

Dave Tufte said...

EC: 50/50

I don't know that I'd say it isn't optimal. Part of what you're supposed to be learning in any Micro or ManEc is that the parties involved in a market have different constraints ... and the constraints are what makes for unusual behavior. They are "where the action is".

Crude oil is an odd good, because it is the one that is most tied up with how individual governments function. It's a little strange, but it's the good which governments have decided belongs to them, and not their citizens. In most locales, governments produce very little that is sold for revenue. And then we have crude oil, which perhaps 20 governments around the world own and sell. And for those governments, oil revenue has turned into a major alternative to having a functional tax system (and by extension a functional government). You can go far in understanding oil markets by realizing that about half of the major crude oil producers (Russia, Iran, Venezuela, Ecuador, Nigeria, Iraq, Kazakhstan, Azerbaijan, Libya, Equatorial Guinea, Brunei) are dysfunctional.

Dave Tufte said...

There's news about oil you may not have heard. I don't normally add free-standing comments at this blog, but this is one of those rare occasions.

1) Probably the biggest name academic economist who studies oil is James Hamilton. Here he is, writing at Econbrowser, about how U.S. oil production continues to surge. If you're only kinda' sorta' aware of the scale of production coming out from horizontal drilling, the first chart will shock you. The second chart is just as stunning, showing how oil in storage tanks has moved way above the normal range over the last 9 months. The third chart shows that, yes, just as predicted by economic theory, this is leading to some wells getting shut down due to lack of profitability. You'd think this would lead prices back up, until you look at the fourth chart, which shows improvements in productivity per well of something like 200% over the last 3 years alone.

2) There's an international glut of oil, but part of the domestic economy that's making our prices particularly low is the ban on exports of crude oil from the U.S. Over recent months, oil exporters have figured out a way to workaround this somewhat by exporting a byproduct called condensate.

3) In the U.S., we now have a shortage of ... wait for it ... oil storage facilities. This is not a result of some limitation on building them, but more from the fact that the amount of storage we've been OK with for decades is completely inadequate for the ease with which horizontal drilling is bringing the stuff to the surface.

Judy said...

I agree with Dr.Tufte, and through net surfing I came to know some of the reasons for the rightwards shift in supply and leftward shift in the demand. Recently the economic growth in China and Germany has noted to be slower; this has impact on the demand for oil in moving it leftward. Interestingly, the popularity of fuel efficient cars (hybrid technology cars) throughout world is also another reason for said movement of the demand curve.
The reason for rightward shift of supply curve is Russia’s unaltered production and supply of oil in world market. Saudi Arabia also is not an exception here. These two countries are ranked as first (Russia) and 2nd (Saudi Arabia) largest oil producing countries in the world. This action signals that both the countries want to retain their market shares at any price level.
Russia’s economy largely depends upon oil production (45%), and in an effort to reinforce the cash inflows they are not cutting short the production of oil. According to World Bank, if the per barrel oil prices remained below $50 till the end of 2015, Russian Economy can shrink by 0.7% and its GDP may drop by 4.5%.
There arises a question; will the oil prices bounce back? The answer to this question is not easy to find out but the probable increase may be observed if the economies of China and Germany bounce back or oil producer Saudi Arabia or Russia decide finally to shorten the oil production.

Dave Tufte said...

Judy: 47/50 (missing a "the" in several places).

This is excellent: you're absolutely right about the slowdown in other large economies.

(I came across a great tool to assess this over the weekend, and now I can't find it on the internet. I will go back to the PC I was on and check the history to see if I can find it. Watch for another comment from me).

I don't know that we can conclude that Russia or Saudi Arabia is concerned about market share. Perhaps for Saudi Arabia, but I think Russia is concerned about the amount of revenue they collect. If so, they might respond perversely in a situation like this, increasing their production to maintain revenue and thus pushing prices down further.

I'm not sure what you mean with the two growth rates for the "Russian economy" and "its GDP". Aren't they the same thing?

Dave Tufte said...

I found the link to that tool I mentioned in my previous comment.

The issue is why have oil prices dropped so much over the last 9 months, and how long can we expect that to continue?

The problem is that this is partly due to supply considerations (Russia not cutting its production, the U.S. ramping up its production), and partly due to demand considerations (faltering economies in China and the EU).

This tool estimates the extent to which those two shifts are important. It requires that you put in 4 pieces of data (it has links to those). I did that this morning, and it says that 75% of the price decline is due to demand rather than supply factors.

If you tunnel down from the page with that tool to the source page, and then crunch some numbers, you'll find that most of the drop in oil prices is due to the appreciation of the U.S. dollar.

That has a direct effect, but it's also a signal. The direct effect is easy: a stronger currency makes buying foreign oil cheaper.

But the signalling effect is that movements in exchange rates often reflect the confidence that investors have in the relative performance of economies and their governments. In America, we bitch a lot about how lousy the economy is and how much some Americans don't like Obama. But the fact is that compared to most other countries, our economy is doing better, and our government functions more reasonably. Since economic performance changes more quickly than political performance, the appreciation of the dollar probably reflects weakening economies elsewhere. This means less demand for oil.

Dave Tufte said...

Ever heard of fracklog? Here's one more thought for our evolving understanding of the low price of oil.

It seems like a lot of drillers in the U.S. have responded to low prices by doing the horizontal drilling, but not the fracking, in their new wells. Basically, they're putting in new wells, and leaving them in a state where they can be productive in a couple of days.

This suggests that prices will be maintained at low levels longer than we might otherwise expect.

Joey said...

I have found this post to be very interesting. I live in the Uintah Basin, which for those of you who do not know is mostly comprised of Duchesne and Uintah counties. In the last few months due to the reduction in the price of oil many companies have closed their doors, gone through massive layoffs, or cut hours to reduce costs. The unemployment in my county has more than doubled in the last few months. The comment was made earlier that Texas and North Dakota are being hit hard by this change, but many people do not realize that there are parts of Utah that are heavily affected as well.

The questions on everyone’s mind in my county are how long will this last and how stable is my job? The reduction in oil prices will affect every industry in my county. Those with inferior goods will likely see an increase in demand while those with normal goods will see a decrease in demand. For employment the market has shifted in favor of employers due to the large influx of applicants. The housing market has also shifted from a sellers’ market to a buyers’ market as hundreds of homes are added to the market each week. While I am happy to pay lower prices at the pump I know too many people who have recently lost their lively hood to be too excited.

Below I have placed a link to give you some idea what the drop in oil prices means for my local economy.

Desseret News

Dave Tufte said...

Joey: 44/50 (you mean "livelihood" and "Deseret".

Thanks for telling us about what's going on up in that corner of the state. I think we probably all know someone who moved up to the Vernal area to over the last few years. I was up there in 2013, and it was pretty crazy.