The dramatic drop in the price of crude oil from around 100 dollars per barrel ($/b) in June 2014 to just over 30 $/b today has produced a wealth of commentary and analyses. Some have focused on the impact that such a steep decline will have on oil exporters, others have discussed the potential benefits to consumers, and there have also been good discussions on fiscal and environmental policy changes.
In a series of technical notes, our team has been taking a close look at the causes of the decline. In essence, we have seen that very quick growth in production from the United States along with a slowdown in economic growth of emerging markets have combined to yield much lower prices than the average of 100 $/b that prevailed between 2011 and 2014. In our first analysis, written when the price dropped from $ 100 to $ 65 per barrel, we describe how in 2014 the annual rate of increase in oil demand in developing economies, particularly China and India, was about half the average between 2011 and 2014. Such a decline in demand alone would have yielded lower prices, but this effect was exacerbated by growing supply from an unexpected source: the United States. As our second paper – completed when the price had reached 45 $/b – describes, oil production in the US had been declining steadily since 1985, reaching a trough of 6.8 million barrels per day (Mbd) in 2008. Since then, the development of unconventional oil reserves found in shale rock formations has nearly doubled production. Today around 11.6 million barrels of oil are produced every day in the United States.
Our most recent publication in this series – as the price hovers around 30 $/b – takes the empirical findings of the two previous publications and builds an analytical framework to understand the new price-setting model that is becoming dominant in international oil market. The exploitation of heretofore untouched and potentially massive oil reserves in the United States represents a very real paradigm changer.
These reserves are being developed by hundreds of firms that are in direct competition with each other and are therefore continuously trying to lower costs, improve productivity, and produce more. The international oil market has rarely seen such a competitive structure. Indeed, as the paper describes, since the creation of the Standard Oil Company in 1880, the market has been dominated by oligopolies that stifled competition. From the 1930s to the 1970s, the ruling oligopoly was the so-called International Oil Cartel, which was composed of large American, British, and Dutch oil companies, collectively known as the Seven Sisters. Since the 1970s, the Organization of Petroleum Exporting Countries (OPEC) has largely established the means through which the price of a barrel of oil was determined.
Under these two oligopolies, output from the most efficient producer was regulated in order to establish the price of oil above costs and yielding monopoly profits for the actors in the market. Today the situation is radically different. The price of oil, currently hovering around 30 dollars per barrel, is at last being set competitively since it is being established by what it costs the most efficient producer to make one barrel. Such a model had essentially never existed in the international oil market, and the consequences of such a mechanism are significant.
Understanding that the price of oil is now set under competitive rules allows us to see, for example, the dilemma that the traditional oil producers face. Traditionally, OPEC and its partners would have cut output to artificially create a shortage and prop up prices. Under the new model, however, a cut in production from traditional producers would simply yield higher output from non-traditional producers like the shale oil companies in the United States as they seek to profit from those higher prices. This marginal price setting model, therefore, is likely to yield a price band between 30 and 50 dollars per barrel, where the price of oil should stay over the next five years. The global and competitive model for the oil market is here to stay.