The Fundamentals of Oil
In the space of a few months, from September to December 2014, the composite oil price index (the OPEC basket of 12 crudes) dropped by half from $100 to $50, and then dropped further in January 2015 reaching almost $40. Is a 50% drop in such a short period of time an extraordinary event for such a fundamental energy input and raw material? What are the causes and consequences?
All those who know history are well aware that oil prices have fluctuated wildly also in the recent past. Over the last three decades, there have been at least six episodes of prices dropping by at least 30% in six months. The most recent one happened in 2008, when the price of oil dropped from $140 to $35 between the months of July and December. But the most significant event occurred in 1985-1986, when the Saudis decided to expand output and the price of oil dropped by more than 60% in a month. It put an end to expectations of irreversibly rising oil prices.
The causes of variations in the price of oil are many, but at the basis of any causal explanation lies the fact that both demand and supply are price-inelastic in the short run. The role of speculation and collusion in supply control on the part of OPEC are also cited among the driving causes. The importance accorded to financial speculation derives from the fact that oil prices are set in New York and London's marketplaces, where the quantities exchanged far exceed those needed for actual consumption. Certainly price volatility is higher in financial markets than in actual delivery markets.
However, academic studies and government committees have concluded that speculation alone is unable to produce a permanent price shock. At the same time, OPEC's market power is more symbolic than real: most members of the oil cartel are unable to rein in production. Only Saudi Arabia (and few others) can modulate output, thereby creating conditions of abundance or dearth in supply. Excess supply is not in the interest of (especially high-cost) oil producers, while artificial scarcity to prop up prices can only be sustained for short periods of time. This is the lesson that Saudi Arabia had to learn the hard way in 1985.
Ultimately, it's market fundamentals and expectations that drive the crude oil price. Currently, there's excess supply due to expansion of (mostly US) oil output and flagging demand. Since OPEC (i.e. the Saudis) announced its intention not to cut production, operators have had bearish expectations about falling prices and rising stocks in the forthcoming months. At the same time, geopolitical risk (the triple whammy of Middle Eastern, North African, and Ukrainian crises) seems no longer unable to counter the rising oil supply trend. Hence the revision of expectations on the basis of existing excess supply, and the sharp drop in prices.
The consequences? Globally, a stable 30% reduction in the price of oil is expected to increase global GDP by 0.5%, although its effect will be far from uniform. In fact, the price decrease causes a variation in real income which favors oil-importing countries and puts exporters at a disadvantage. In importing countries, the cut in prices boosts consumption and GDP, although currency markets have to be brought into the equation, too. For instance, considering the EU, the effect of a rising dollar has nullified 15% of the reduction in crude prices. For every country, we'll also have to see how consumers will react and which policies governments will implement. In the case of Italy, a major oil and gas importer (gas prices are partially pegged to oil), the effect of falling prices is bound to be positive and could help overcome years of negative growth. But only if consumers increase purchases, and the government resists the temptation to raise gasoline taxes.