Last summer, after an unusually long period of relative stability, oil prices embarked on a downward journey, decreasing by half in just six months. In the last few weeks, however, the market has worked on establishing a floor, enabling prices to regain some of the lost ground. Even so, they are unlikely to return to $100 a barrel soon, and the consequences of the plunge have yet to play out fully.
The reasons for the sharply lower oil prices include increased supply from both traditional and non-traditional sources, such as shale; lower demand, particularly from high-intensity users such as China; and a change in the willingness of the Organization of Petroleum Exporting Countries, and Saudi Arabia in particular, to continue to play the role of swing producer (lowering production in response to declining prices, which in the past provided an earlier and broader floor for the market).
The shock to oil prices reflected what economists would characterise as unusually unfavourable movements both on and among supply and demand curves. These developments in combination caught many off guard. Now, however, the sharply lower oil prices are inducing enormous supply destruction that has yet to run its course: The price drop has rendered many existing oil fields uncompetitive, curtailed alternative energy sources and stalled longer-term expansion investments. While this supply destruction buttresses oil prices in the short- and medium-term, there are three strong reasons it will probably prove insufficient to lift prices back to the level that prevailed in the first half of last year any time soon.
First, significant demand creation appears to be materialising more slowly than expected. Part of the reason is specific to the energy market, including consumer uncertainty about the durability of lower oil prices, and the costs involved in altering energy consumption patterns. Another contributor has to do with general hesitation to take economic risk, as opposed to financial risk, particularly for companies that might consider expansion and capital investments.
Second, lower prices have created economic, financial and political pressures on some oil-producing countries – Nigeria, Russia and Venezuela – that, under certain conditions, could entail future disruptions in their supply to the global energy market. The impact has been to accentuate concerns about instability in countries such as Iraq and Libya. Third, Saudi Arabia reaffirmed its November decision not to play the role of swing producer, and the oil minister added that this approach would be proven correct. More specifically, this time, the output reduction will be borne less by OPEC and more by higher-cost non-OPEC producers. As such, OPEC – and Saudi Arabia in particular – won't need years to re-establish some of lost market share.
Assuming there is no major geopolitical shock, there are three implications for oil prices for 2015. First, expect continued consolidation, though volatile at times, with a tendency toward higher oil prices over the course of the year. Second, there will be no quick return to the $100 level. Third, low-cost producers of oil and traditional energy products will expand their market share.