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How Low Can Oil Prices Go?

Investopedia logoInvestopedia 30-04-2015 Alison L. Deutsch
Oil prices are experiencing record lows. While this comes as a welcome development for consumers, oil companies are struggling with choosing market share over profitability. © Thinkstock Oil prices are experiencing record lows. While this comes as a welcome development for consumers, oil companies are struggling with choosing market share over profitability.

In recent months, Americans have been greeted with relatively cheap gas upon filling up at the pump. Oil prices are experiencing record lows and gasoline prices are at the lowest levels the market has seen since 2010, with some areas of the country enjoying prices of less than $2 a gallon. While this comes as a welcome development for consumers, oil companies are struggling with choosing market share over profitability.

As prices fall, what are the short- and long-term implications for the oil industry? Will consumers continue to line their pockets as domestic and global oil prices plummet? This article will break down the causes for the current price drop in the oil market and the outlook on oil prices.

The Case for Price Decline

Although the varieties of crude oil are plentiful, there are two that serve as accepted industry benchmarks: West Texas Intermediate (WTI) and Brent. WTI, the domestic standard for light and sweet oil and the focus of U.S. reports, has weathered a near 60% drop in barrel prices. Over a nine-month period ending mid-March 2015, West Texas oil prices dropped to $44 per barrel from $107.

During the same period, Brent oil endured a 50%+ reduction in pricing, from $114 to $52. Brent Oil, a sweet light crude from the North Sea, is widely accepted as the marker for global oil purchases and a better indicator of the worldwide market, especially in Europe and the Middle East.

In June of 2014, the going rate for regular unleaded gasoline at the average U.S. gas station was $3.65, compared to $2.45 in mid-March of this year. Though a significant 33% shift in price, this figure is nearly half of that reflected in the drop in overall barrel price. This is because in addition to crude-related costs, the price of gas also accounts for expenditures associated with refining, taxes, and distribution, fairly predictable costs that are less likely to fluctuate. (For more, see: What Determines Oil Prices?)

Why the drop in crude prices? The current price plunge can be attributed in part to the following factors:

Basic Supply and Demand- The globe, and the United States in particular, is awash in oil. Thanks to hydraulic fracturing (fracking) and horizontal drilling technological advancements, the United States has ramped up shale production and is even storing excess oil for future use. Domestic oil inventories have reached their highest levels in 80 years, and the United States has replaced imports with its own supply. Of the energy it consumed in 2014, the United States supplied 89%, dramatically reducing its dependency on imported oil from foreign actors.

America’s growing oil storage, coupled with slowing economic growth in Europe and Asia (most notably China) has softened the global demand for oil. Despite a waning global demand, top oil producers are continuing large-scale production efforts.

The U.S. Dollar- Successfully moving past the recession, the United States is enjoying a prosperous recovery. One product of the nation’s growing economy is an increase in the value of the dollar. Right now, relative to other currencies, the U.S. dollar is strong. Like many other commodities, oil is denominated in dollars and thus costs less in the United States than in other countries. As a result, prices are falling less for the countries that need cheap oil the most. This adds pressure to already struggling economies and further reduces both the demand and price of oil as countries buy less.

Geopolitical Factors- Global conflict has long dictated market forecasts. Analysts initially believed current civil wars in Iraq in Libya would disrupt supplies, however this did not happen. Libya’s production has tripled since June of last year and Iraq is pumping 3.1 MMbd.

Oil prices could also continue to fall if a deal is reached between Iran and the United States on Tehran’s nuclear program. If negotiations proceed, sanctions will be lifted and Iran would enter more crude oil exports into the oversupplied global market. Prices have already dropped prematurely as recent developments suggest talks are moving ahead.

Will Prices Rebound?

At least for the next several years, industry executives believe prices will remain lower for longer. In the U.S., production continues even as oil companies reduce the number of active rigs. The number of U.S. drilling rigs dropped this week to the lowest level since 2010. However, crude stockpiles haven't been this high since 1930.

Oversupply efforts by OPEC (the Organization of the Petroleum Exporting Countries) states, led by Saudi Arabia, are also likely to persist. In a strategic bid to dominate market share over rising prices, Saudi Arabia, the world’s largest crude oil exporter, is maintaining production to undermine its competitors. The Middle Eastern nation, flush with cash from foreign assets, is prepped to survive revenue declines.

Lower prices would lead to supply disruption in Iranian, Iraqi, and Libyan markets, which all need sustainable oil prices in order to profit. Efforts to shore up investment capital to develop deep water reserves and shale deposits by countries like Argentina and Venezuela would prove uneconomic. Lower prices also damage U.S. shale which may not be economically viable below certain levels.

As slow economic growth is predicted in most of the developed world and emerging markets, decreased oil demand is likely to follow. China especially is experiencing its slowest pace in decades, with economic growth decelerating in 2014 to 7.4%.

However, there are factors that could rebound current oil prices. The U.S. dollar could decrease in value. Oil demand could easily rise in the wake of an unexpected weather event, threatening local supplies. Ever-changing geopolitical climates also contribute to the price in crude as evidenced this week when Brent gained on the crisis in Yemen following Saudi airstrikes. (For more, see: Introduction To Trading In Oil Futures.)

The Bottom Line

Global oil production is outpacing consumption. OPEC members have not adjusted production levels accordingly despite a surplus in oil production, and the American shale boom is generating 4 million barrels/day (MMbd), up from 1.2 MMbd last year. Unless production is curbed or foreign demand grows as markets strengthen, oil prices are not likely to rise in the approaching months. This is great news for American consumers, but not so much for the country’s top oil CEOs.

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