1. NS4960 Spring Term 2018 The Oil Price Plunge of 2014
Windfall: Behind the Oil Price Plunge Chapter 1

2. Overview
Chapter traces the developments that eventually lead up to the oil price collapse in mid-2014
During the early 2000s the general feeling was that in the future the demand for oil would be outrunning its supply
Since there is a finite amount of oil easy to conclude that world reaching point of “peak oil”
Some analysts were predicting that government efforts to develop alternative energy – solar, wind might dampen energy price increases but not stop their rise
Big surprise was that the big surge in energy production would be in oil and gas

3. Shale Revolution
New technologies for obtaining oil and gas from shale being developed
First – hydraulic fracturing
Second – horizontal drilling
Techniques not of interest to oil majors
Instead have been pioneered by small, new companies
Companies took advantage of
Readily available finance
Private ownership of subsurface minerals
Competitive environment spurred innovation
Major increases in oil and gas production started around 2007

4. Conventional/Unconventional oil and Gas

5. Shale Gas Expansion

6. Expanded U.S. Oil Production
Increase in American oil production significant
4.9 million b/d by March 2015
Total global demand 96 million b/d
Did not drive price down but inadvertently contributed to price stability
Instead of leading to glut – substituting for Middle East oil shortfall caused by political disruptions

7. Crude Oil Production (million barrels per day)

8. U.S. Middle East Oil Substitution

9. Dethroning of OPEC I
To understand origins of new oil abundance and subsequent oil price decline need to look at decision making in
Saudi Arabia and
OPEC
Saudi Arabia had faced similar problem in the 1980s
After OPEC price increases in 1970s conservation in consuming countries reduced demand
Weak world economy also put slack in oil markets
OPEC cut production by one half, but did not work
Non-OPEC oil was on the increase
Saudi Arabia forced to bear brunt of cuts

10. Dethroning of OPEC II
Saudi Arabia pursuing what many observers felt was a dominant firm pricing model.
Saudi Arabia sets price and lets other producers adjust to that price
However price profitable, so other producers expand production at SA expense
By 1985 SA producing at one third 1980 levels
Increasing non-OPEC supplies meant SA losing market share
Faced with cheating OPEC members and declining prices, SA abandoned restraint, increased production and prices fell further.

11. Dominant Firm Model

12. Saudi Arabia in 70s and 80s

13. Situation in 2014 I
Clear now that 1980s experience affected way SA responded to oil markets in 2014
Beginning of 2014 oil prices still around $100 per barrel – had been at that level for several years
Most Saudi leaders did not see surging U.S. shale oil as a problem
Because oil producers had expanded expenditures following Arab Spring in 2011 the break-even budget price of oil was over $100
As price fell below $100 in autumn 2014 many thought for budgetary reasons SA and OPEC could not afford to let prices sink too low

14. Pattern of Oil Prices

15. Situation in 2014 II Saudi Arabia dilemma Problems
Cut production to stabilize price, but loose market share
Do nothing and hope low price would drive shale producers out of business
Problems
Did not know break-even price for shale producers – thought it might be around $80 per barrel.
Shale production very flexible – takes only a few weeks to bring new wells into production
SA could not count on others like Iraq, Iran and Nigeria to cut production
Led Saudi Arabia to conclude that if it stabilized price, SA could only benefit for a short period before extra production flooded market

16. Situation in 2014 III
SA concluded oil prices probably would not drop much below $90 if it did nothing
SA in a good position to bring on lower oil prices
Country had virtually no debt
From good years had accumulated more than $700 billion in reserves
At OPEC meeting in November 2014 members voted to maintain production at 30 million b/d
Shock to markets and
Oil prices began to fall
Shale production did not decline
By early 2016 price had fallen to $28 per barrel

17. Price of Oil , July 2014-January 2016 (dollars per barrel)

18. Conspiracy Theories
Oil price collapse spawned a number of conspiracy theories
Putin – agreement between the U.S. and SA to punish Iran and affect economies of Russia and Venezuela
Iranians – Conspiracy by certain countries against region and Islamic world
Conspiracy theories confuse correlation with cause
Oil price drop did hurt SA adversaries, but probably best explained by economic theory – dominant firm model
Model would suggest best strategy not to cut production but drive fringe firms out of market
Then raise price and recoup short run losses.

19. Assessment
Geopolitical explanation of SA and OPEC’s approach does not explain why action happened in 2014
Iran and SA locked in competition for years
Major lesson for anticipating future oil pieces
Never underestimate human ingenuity and innovation in overcoming resource scarcity
Means extrapolation of historical price trends likely to always forecast higher oil prices than will actually occur.