Price of Oil Continues to Drop

posted on 12.11.14

Need to Know . . .

  • The price of oil has declined by 39% since June
  • The decline in the price is attributable to the almost 4 million barrels per day increase in U.S. oil production since 2008 and slowing growth in world oil consumption
  • Barring increased turmoil in the Middle East, the price of oil is likely to remain low through 2015

The financier J.P. Morgan was once asked by someone looking for investment advice where he saw stock prices going. He opined something to the effect that prices will fluctuate. He was right of course, and today we can say the same regarding the price of oil. Following OPEC’s decision at the end of November to maintain production at its current level, the Brent spot price of oil closed at $70.02 per barrel, down 39% from its closing price of $115.19 on June 19, 2014 (Figure 1). Similarly, the WTI spot price fell by 39% over the same period, closing at $66.15 at the end of November. What’s next? Will the price of oil continue to fall, and if so, how far? Will the price of oil level out? Or will it rebound?

Figure 1 – Spot WTI and Brent Oil Prices

Source(s): U.S. Energy Information Administration and MAPI Foundation

Learning From History
This is not the first time the price of oil has fallen sharply. In July 1986, the imported price of crude oil (measured in current dollars) fell to $10.91 per barrel, down 59% from one year earlier and by 72% from February 1981. The price slowly rebounded to the end of 1996, when it hit $23.22 per barrel. Then it slid for two years and by December 1999 was down to just $9.39, or by 60% from two years earlier.

Throughout the period from 1986 through 1999, U.S. petroleum consumption trended upward. By 1999, consumption was 3.2 million barrels per day (mm b/d) above its 1986 level. World oil consumption also increased, rising from 61.8 mm b/d in 1986 to 91.4 mm b/d in 1999. U.S. oil production fell from 8.97 mm b/d in 1986 to 5.88 mm b/d in 1999. Thus, despite growing demand for oil, the world price remained fairly low compared with levels reached in the early 1980s following the Arab oil embargo and the Iranian Revolution. The reason the price of oil stayed low is that world oil production continued to increase. OPEC lost its ability to maintain cohesion among its members and its production steadily increased from 17.6 mm b/d in 1986 to 27.2 mm b/d in 1999.

After 1999, the price of oil increased steadily as a result of growing consumption in the United States, China, and the rest of Asia. By 2008, there were concerns that slowing production growth coupled with the expected growth in the demand for oil would cause oil prices to soar.

The U.S. Shakes Things Up
U.S. oil production has grown by close to 4 mm b/d since January 2008. This increase is the main reason the price of oil is falling. Given the slowdown in the rate at which world oil consumption is growing and expectations that U.S. oil production will continue increasing, the price could fall even more. Further, it could be a few years before there is any upward pressure on the price of oil. Analysts at Deutsche Bank argue that if OPEC production is not reduced, the gap between world oil production and consumption will grow in 2015, thereby putting downward pressure on the price of oil.

There is uncertainty as to the extent to which U.S. oil development could be deterred by the lower price of oil. The consensus seems to be that as long as the price remains above $65 per barrel, there would not be a significant reduction in development.

Looking Ahead
There are two other variables to consider. First, other countries with shale reserves (including China, Russia, the United Kingdom, and Argentina) are eyeing the U.S. shale revolution; if they proceed to develop these reserves, the price of oil will continue to be under downward pressure. Second, total U.S. petroleum consumption has been flat since 2008 and is projected by the U.S. Energy Administration to fall an annual average rate of 0.1% between 2012 and 2040, despite economic and population growth. Gasoline consumption is projected to fall at a rate of 1.0% per year. The expected decline in petroleum consumption reflects the impact of continued improvements in energy efficiency, including the CAFE standards that require new cars to average 54.5 miles per gallon by 2025.

Thus, OPEC must worry not only about growing oil production by the United States and other countries, but also increasing energy efficiency. While a strong case can be made for continued downward pressure on the price of oil, it is important to recognize that events can quickly change the situation. For example, if unrest in the Middle East and Africa were to grow to the point where Iraqi, Libyan, and Nigerian oil production is further disrupted, or if Saudi production is perceived to be at risk from those opposed to the Saudi regime, the price of oil could rise sharply and quickly.

Article provided in partnership with the Manufacturers Alliance for Productivity and Innovation.  Written by Donald Norman PhD, Senior Economist.