Oil Prices: Behind the scenes
Since 2014, the oil industry had begun tumbling down with many oil exporting countries suffering dearly.
Oil prices plummeted from being $115 per barrel in 2014, to under $35 at the end of February 2016. Oil exporting countries such as Russia, Angola, Nigeria, Iraq, Saudi Arabia and Venezuela have taken a massive blow. Saudi Arabia’s government had a staggering $100 billion budget deficit in 2015 and Angola, which gets 95% of its foreign currency from oil sales, is now in peril. Angola had grown immensely with the development of oil industries after the civil war. Because of the shortage of foreign currency, the national currency has devaluated greatly and the country is limited to the amount of food and manufactured goods it can import.
The price drop also led to oil companies decommissioning around 60% of their rigs and reduced their investment in exploration and development, which in turn resulted in the loss of dozens of thousands of jobs and an increase in unemployment.
Understanding what is behind the price drop is crucial to grasp what macroeconomic effects it might have. Like most cases, the oil price drop is mainly determined by supply and demand. The production of oil in the United States has doubled over the past few years, resulting in a significant reduction in oil imports creating a lot of spare supply in the global market. The global demand growth rate is in decline as the world becomes more energy-efficient and renewable energy start to take its space. This means that the global market has become oversupplied with oil and gas, driving prices down.
On the other hand, the increase in value of the US dollar has also contributed to the low crude oil prices. The USD is a currency of international trade and if the value of USD increases, it would mean that the oil prices would have to decrease to return to its original value. For example, if the price per oil is $55 per barrel, it would mean that the price per barrel would be 45.58 pounds in the UK and 52.56 euros in most European countries. If the value of the US dollar increases by 5%, the price per oil barrel would cost 50.13 pounds and 57.81 euros respectively. However, other countries are ready to pay only a set value, the original value. Thus, the price per oil barrel must fall to 52.25 USD. This showcases that the relation between oil prices and the value of US dollar is negatively correlated.
The Organization of the Petroleum Exporting Countries (OPEC) has been pressured to cut down production to stabilise the oil prices. However, Saudi Arabia, the biggest OPEC producer, has been reluctant to cut down production to avoid losing market share, while other OPEC countries like Iraq and Iran refuse to reduce production and sacrifice their market, with fear that their economy will fall. The good news is that OPEC, along with Russia and other oil producing nations, has agreed to limit their production for six months, starting in 2017.
Brent crude oil prices are currently being traded at $54 a barrel which is slightly higher than last year’s average of $42.3 a barrel. So, there is evidence of improvement and prices are likely to recover over the next three years. The question remains whether the recovery can be sustained over the long term, given the renewed commitments to reduce global warming at the Paris agreement in December 2015.