Tumbling of crude oil prices: Economic laws say

that this is a temporary phenomenon

A drastic reduction in crude oil prices-December 22,

2014
Crude oil prices in the world market have tumbled and they are still
tumbling. The average price of the West Texas Intermediate category of
crude oil stood at a level of $ 100 per barrel, which is equal to 159 litres a
few months ago. It has now fallen to a level of $ 60 per barrel last week.
This is practically a decline of 40% in an important commodity within a few
months.

Supply has grown faster than demand causing prices to fall.

The price of any commodity falls mainly due to that commodity having an
excess supply. An excess supply can occur due to a fall in demand or an
increase in supply or both. In the present situation, when the Northern

Hemisphere of the globe goes into winter, the demand for oil products
normally rises because of the need for heating. Hence, if there is an excess
supply this winter, it is mainly due to the supply of crude oil rising faster
than the increase in demand.
Two theories have been raised to explain the current excess supply of crude
oil in the market. One is economic and the other is political.
The US going into tapping shale oil resources
The economic reasons are less unknown in this part of the world. That is,
the United States has, in a big way, explored oil in new oilfields known as
shale oil fields by using a new technology called fracking which is the
shortened form of what is ordinarily called fracturing.
Oil shale refers to a rock situated about 4-5 km beneath the
surface of the earth containing solid bituminous materials
called kerogen that are released as petroleum-like liquids by
heating the rocks (available at:
http://ostseis.anl.gov/guide/oilshale/ ).
The shale oil is in solid form and therefore cannot be pumped
to the ground like the oil that is extracted from conventional
oil fields. Hence, even though the availability of oil in shale
rocks was known for centuries, the commercial exploitation of
shale oil did not take place until the early part of the second
decade of the new millennium.
Even as late as 2011, the US Bureau of Land Management
had concluded that there are no economically-viable ways
yet known to extract and process shale oil for commercial purposes.
The fracking technology to bring shale oil up
But this was not to be for long. A new method of tapping the vast deposits
of oil and gas contained in shale rocks was used on a commercial basis in
the US after around 2012. That was called hydraulic fracturing or simply
fracking.
With this method, what is being done is that a vertical hole is drilled up to
the formation of shale rocks, which are located about 4 km below the
ground level. This vertical drill is continued horizontally through the shale
rock similar to the donas which one finds in gem pits in Ratnapura. Then,

about 4 million litres of water mixed with sand and chemicals are injected
at high pressure to the horizontal section of the drill causing the shale rock
to fracture and crack open, similar to the fracturing which may happen in a
bone of the body when it is subjected to a heavy blow.
The fissures created by the fracturing are kept open by the sand that is
released along with the water mixture. It causes the shale rock to release
the gas and oil which had been contained within it for many millions of
years. The oil and gas mixed with water are then pumped back to the
ground, separated and used for further processing. The recovered water is
first stored in open pits and then removed to treatment plants.

The fracking revolution

Fracking has revolutionised oil and gas
exploration in the world. This was
hitherto a commercially untapped
resource and now it is being tapped on
a massive scale, especially in the
northern part of the United States.
Its sudden proliferation has helped the
United States to boost production of
both these energy items. By 2014, the
US became self-sufficient in natural gas
and in the case of oil, emerged as the
worlds largest producer of crude oil,
driving Saudi Arabia down to second
place.
It is estimated that by 2020 the US will become self-sufficient in crude oil as
well. This was good news for Obama administration which had been
beleaguered by all for a lack of visible economic recovery in the country.
Hence, despite the protests against fracking on environmental grounds, the
Obama administration is openly supporting the new oil exploration venture
which US companies have undertaken.
The worlds fracking mania
Shale oil is not confined only to the US. It is abundantly available in the

southern provinces of Canada, Lithuania, China and New Zealand. After it

was proved that fracking technology was a commercial success, all these
countries have now started plans to exploit their shale oil resources. The
increased oil and gas production in the US has reduced its imports creating
a glut in the current energy market, sending prices down.
Planned future shale oil exploration by other countries will keep the market
glut going for many more years. The current surplus as well as the expected
surplus has sent oil prices tumbling in the world market. That is the
economic reason for the present decline in oil prices.
A conspiracy theory to explain falling oil prices
The political reason is associated with a popular conspiracy theory. The
present glut has been augmented by Saudi Arabias refusal to cut oil
production to match the reduced import demand to maintain oil prices at its
historical average of $ 100 a barrel.
The Saudis have rationalised that even if oil prices have come down to $ 40
a barrel, they would still not consider cutting oil production. The present low
oil prices are a loss to Saudis and other members of the Organisation for
Petroleum Exporting Countries, popularly known as OPEC. But if prices
further tumble to a $ 40 level, their losses would be augmented beyond
recovery.
In this background, what has prompted the Saudis to stubbornly refuse to
cut oil production? The conspiracy theory has been harboured to justify this
irrational behaviour.
Bringing Russia to its knees
It has been argued that the Saudis want to punish three parties by allowing
oil prices to fall in the market. First, it is to punish Russia which is
supporting the Assad regime in Syria which the Saudis want to topple.
Russia is heavily dependent on its oil resources for financing the budget and
earning foreign exchange. About a half of its budgetary revenue and about
60% of its export earnings come from the oil sector. When these earnings
dwindle on top of the present economic sanctions against Russia by the US
and the EU on account of its expansionary policy toward Ukraine, Russia is
expected to fall to its knees, fully appreciating the emerging stark economic
realities.

Already Russia has been punished by these two counts: its currency, the
rouble, has fallen in the market from around 30 roubles a dollar to 70
roubles a dollar. The Russian Central Bank is desperately trying to keep the
rouble from further falling by releasing some of the dollar reserves it is
holding and increasing interest rates to an unprecedentedly high level of
17% per annum. Both these measures are expected to punish Russia in the
long run by shrinking its economy.
Punishing Iran for having nuclear ambitions
The second party which it is claimed that the Saudis want to punish is the
unfriendly regime in Iran. Irans nuclear ambitions have been considered by
the Saudis as a threat to their existence. Since it is unlikely that Western
sanctions against Iran could force the regime to abandon its nuclear
ambitions, it is said that the Saudis want to make their own attempt. That
is, by forcing oil prices to fall in the market and maintaining them at those
low levels for sometime the Saudis want to deliver a fatal blow to that
country.
Damn the US shale producers
The third party to be punished, according to this conspiracy theory, are the
shale oil manufacturers in the US. Tapping shale oil resources is a costly
affair and if oil prices fall below $ 80 per barrel, given the current cost
structure, the boom in the shale oil sector in the US will come to a sudden
end. Thus, it is alleged that the Saudis want to eliminate one of their rivals
who has resorted to alternative oil exploration.
Can the Saudis be on a self-destructive path?
This conspiracy theory is rationalised by pointing to the low cost of the
production of crude oil in Saudi Arabia. Since Saudi oil is found pretty close
to the surface level, it is blessed with the lowest cost among all the oil
producers in the world.
Its costs range between $ 15 and $ 25 per barrel whereas in all other
countries they are above 50 per barrel. So, the Saudis can still survive even
at a price of $ 40 per barrel whereas all other producers, including the USs
shale oil producers, will vanish from the market at that price level.

It is economics and not conspiracies which rules markets

Many believe in this conspiracy theory because it is exciting and appealing
to the popular sentiments of people. It is the big and powerful guys who are
to be punished and not the poor nations in the world. Hence, a conspiracy
theory which suggests that the US is going to be punished has much more
appeal than any other conspiracy theory.
But if this conspiracy theory is true, then, the Saudis are on a selfdestruction path. Saudi Arabia depends principally on its oil sector for
wealth, export earnings and prosperity. If oil prices are at a low level for a
significant period of time, it is Saudi Arabia which is to suffer more than
those countries which it wants to punish. Further, though the Saudis can
withstand and survive through a price reduction, all other members of OPEC
cannot do so due to the high cost of oil production by them. Many such
producers, especially Venezuela and Nigeria, have to close shop if they are
hit by such an external oil price shock.
It is therefore unlikely that any rational decision-maker would go for such a
self-destructive choice. Hence, it is more likely that these punishments are
simply a natural consequence of the present global oversupply in oil rather
than deliberate action taken by one of the leading oil producers.
Markets reaction to low oil prices
Thus, the natural market forces will do a series of market adjustments to
correct the current fall in oil prices. Pressure would be exerted on Saudi
Arabia to cut output and thereby bring oil prices up again. Investors in shale
oil in the US, finding that their oil wells are no more economical, will
voluntarily restrict oil production thereby permitting oil imports to the US
once again.
Those countries which are blessed with shale oil deposits will postpone their
plans to tap this resource thereby taking out the expected market supply of
crude oil due to new shale oil exploration. Accordingly, market prices will
start moving up once again and get stabilised at around $ 80 to $ 90 per
barrel. That price is an economic price for all other oil producers in the
world.
Low oil prices are an inhibiter to Sri Lankas Mannar Basis ambitions
Sri Lankas current oil consumption stands at about 1 billion litres of petrol

and 2 billion litres of diesel per annum. It would have gained a significant
benefit due to the low oil prices had it not increased its vehicle imports in a
large measure in the recent past through a supporting duty reduction.
Vehicle registrations are increasing at a rate demanding more oil and diesel
imports. Accordingly, though the price is low, the volume will increase,
reducing the total benefit which the country would have gotten out of the
decline in oil prices in the world market.
Sri Lankas nascent oil exploration efforts in the Mannar Basin will also
suffer if oil prices are at a level of $ 80 or below. These offshore oil
explorations are such a costly affair, even North Sea oil producers cannot
survive unless oil prices have risen to a level of $ 90 and above.
If the prices are lower than this threshold price, the Mannar Basin oil could
be pumped up only with a supporting subsidy by the Government. Hence, it
will be more economical for Sri Lanka to keep the oil under the sea level in
the Mannar Basin instead of taking it out.
The current price fall is a temporary phenomenon
Therefore according to economic logic, the current tumble of oil prices in
the world markets is going to be a temporary phenomenon. They will
remain at these low levels only for another six to eight months. After that,
prices will settle once again at a level of around $ 80- $ 90 a barrel.
(W.A Wijewardena, a former Deputy Governor of the Central Bank of Sri
Lanka, can be reached at waw1949@gmail.com )