A New Equilibrium

Professor of Economics
A New Equilibrium
A New Equilibrium

Are you interested in the oil market? Great! Now here comes the second question: Do you live in a  country that produces the black gold and its economy is heavily dependent on oil exports? If so, just a simple FYI: the price of a barrel of crude has reached the average level of USD 81 and continues to fall.  

Only three months ago the oil was selling above the $100 benchmark. The point is simple: your country has lost revenues.  

In the case of many, if not all, members of the Organization of the Petroleum Exporting Countries (OPEC) they have lost already committed revenues, which will push their annual budgets into the red and provoke inflation.

Now the key query: Why this has happened? The price of oil lodged above $100 a barrel so comfortably that many talked of a new equilibrium.  They did not expect to see prices plunge below $100. The analysts were right; the market was at a new equilibrium then. That is the old equilibrium now.

Economists and veteran business analysts can go on and on talking about the difference between a static analysis and it’s dynamic counterpart. Their main argument is simple and as ancient as the history of mankind: the realities of marketplace change. Since the discovery of oil market cycles have been dominated by the shifts in demand and supply.

These shifts, in their turn, are usually initiated by the changes in consumption patterns, industrial evolution and the discovery of alternative energy resources.  It must be noted that often the transformation of price is the outcome of changes in all of these.  Right now the market is facing a demand which is growing slower than before, a supply which is on the edge of surplus, an organization losing its battle to maintain its dominance over the market, and the emergence of a host of alternative renewable energy resources.

Firstly let’s discuss demand.  Whenever there is an upsurge in prices demand for energy efficient technology increases, for a simple reason: consumers do not want to pay a lot more to use the same product, vehicle, instrument or machinery. As the demand for new technology increases innovators and manufacturers introduce new products that are more energy efficient. When the new products enter the market a new energy consumption pattern takes shape. In other words, beware and not get too excited about increase in the price of oil. It will simply not last.

Right now the shift in energy consumption is showing its impact on the market. To this one must add another factor: China. This huge country of 1.3 billion people is the world’s second largest economy. Its rapid economic growth fueled the rise of oil price in the previous decade, but its growth is now slowing down.  Although it continues to buy as much oil as before, no one expects its demand for oil will increase as fast as before. So, the oil market is looking into the future and there is no significant increase in demand from one of the largest consumers.

Secondly, a shift has occurred in production and it is called Shale Oil. Fracking has increased oil production. True, the new technology is expensive and is most responsive to volatile oil prices. However it is here and the word many use to describe its impact is “tremendous”. US oil production is surging and its oil imports are shrinking. Do not forget that the OPEC members have not cut production for the past six year and Russia‘s oil production is at a historical peak, producing 10.6 million barrels a day. No one is cutting production, so if anything most analysts and market participants expect to see is an increase in supply. Given the slowing demand such increases in supply can only have one effect: plummeting oil prices.

Fluctuations in demand and supply are not the only factors here. With the US and Russia gaining prominence in the global oil market and producing more oil than ever, observers doubt that OPEC has the same market influence it had once upon a time. Its member countries might agree on reducing production and even introduce a price floor. However their efforts may not have the same result as before. With the US and Russia ready to step in the market, OPEC would apparently be more concerned with protecting market share and export markets than preventing the slide in oil prices. This is another new reality one must take into account looking into the future.

True the Middle East remains in turmoil. However, the market participants by now have learned a few things about turmoil and civil wars in this part of the globe.  Buyers and sellers know that while IS is a terrorist group that has seized a few oilfields in Syria and northern Iraq, it is not threatening Iraq’s ability to export oil. Iraqi government forces and other anti-IS fighters have stalled the terrorists north of Baghdad. As long as IS does not reach Basra, oil markets will ignore its existence. It is estimated that the only impact IS has on oil prices was a $5 a barrel risk premium. This premium has evaporated when oil markets were assured that IS will not move beyond Baghdad (and to this Iran has contributed significantly). So it seems for now the oil market will remain rather accustomed to Mideast instabilities.

All these parameters have come together to signal the beginning of a new trend for the price of oil: a declining one at that. Analysts of all persuasions are busy adjusting their estimates of oil prices for the  coming years and months. According to Reuters the analysts at Credit Suisse have cut their 2016 Brent oil price forecast to $93 a barrel, the second-lowest among analysts polled by Reuters. The consensus OILPOLL for that year was over $101. A new equilibrium is on the horizon.  Oil producers better take note.

Associate Professor of Economics, College of Business, Clayton State University, Morrow, GA 30260, USA.