Behind the curtains of the oil price plunge
- While most economies in the world kept growing between June 2014 and January 2015, oil prices fell by 60%
- The plunge seems to be driven by supply side factors, such as a supply glut and changes in the structure of the oil market, such as technology driven changes in the economics of exploration and a changing OPEC role
- Slower than expected demand growth also played a role, while financial trading had a significant exacerbating role
- Looking forward, as oil market fundamentals have undergone significant changes and markets overshoot, one can expect oil prices to become more volatile
After several years of sustained high values oil prices started falling in June 2014. By the middle of January 2015, Brent oil prices had dropped almost 60% (figure 1) before slightly recovering afterwards. Before the plunge, the price of Brent oil had reached USD 115/barrel(bbl) on 23 June 2014, on the back of geopolitical supply risks that had dominated the headlines in the first half of the year, but most of which did not materialize. Yet, geopolitical risks were not the main drivers for the steep decline. So what caused it?
The fall in oil prices may seem counterintuitive since in recent years global economic activity has kept growing in most parts of the world, though it disappointed in many regions (figure 2).
According to economic theory, prices are formed as a result of the interaction between demand and supply. However, in the case of highly liquid products traded on international financial markets, sentiment also plays a role. On top of that, oil is a non-perishable good that can easily be stored. Thus, expectations about the future have a significant impact on current prices, because trading parties alter actual demand and supply by taking positions in oil and oil products based on their expectations. So, while growth stayed positive in most parts of the world in the second half of 2014, it fell short of market expectations, which contributed to the fall in oil prices. The role of financial trading has received particular attention in economic literature as the sharp increase in oil prices between 2004 and 2008 was accompanied by a marked increase in financial trading in oil-related instruments. For example, open interest (the number of future contracts entered into and not yet liquidated, both long and short positions) in WTI future contracts more than doubled between 2003 and 2008 (Alquist & Gervais, 2011).
Notwithstanding recent years’ increasing impact of financial trading on oil prices, this is not the first time oil prices take a dive. In 1985/86, oil prices fell by around 60% within four months and in 2008 by almost 80% within five months (figure 1). The significant economic impact of such oil price shocks has led to extensive research on the factors affecting oil prices (Breitenfellner et al., 2009; Fattouh et al., 2012; Hamilton, 2009; Kaufmann, 2011; Wurzel et al., 2009). Most economic literature reviewed distinguishes three fundamental categories of oil price determinants. The first category includes factors that impact the demand for oil, namely economic growth and energy intensity. The second category includes factors that influence the supply of oil. This category can be divided into two groups, namely 1) factors that have an impact on prices through direct impact on the level of supply such as production capacity, oil reserves and geopolitical risks and 2) factors that have an impact on prices by altering the responsiveness of supply to them such as market tightness, market structure and the economics of exploration. Technological progress is also an important factor affecting oil supply. While the literature does not mention it specifically, it is implicitly included in factors such as current production capacity and reserves. The third group of oil price drivers is related to financial trading, and is usually divided amongst hedging activity, speculative behaviour and the USD exchange rate. In general, there is no consensus on which of these determinants is statistically significant or has the highest impact on oil prices, or whether fundamentals are more important than expectations. For example, Alquist and Gervais (2011), Fattouh et al. (2012), Hamilton (2009) and Wurzel et al. (2009) argue fundamentals are the main price drivers, but Cifarelli and Paladino (2010) argue speculation plays a significant role, while Kaufmann (2011) concludes that both contribute to oil price changes. However, there is an agreement on the fact that the elasticity of both supply and demand to oil prices is particularly low, especially in the short term (Alquist and Gervais, 2011; Breitenfellner et al., 2009; Cifarelli and Paladino, 2010; Kaufmann, 2011; Wurzel et al., 2009). Thus, very large price changes are needed to lead to a change in either demand or supply.
Oil price determinants also received a lot of attention because their nature is important for estimating the economic impact of oil price shocks (Breitenfellner et al., 2009). A supply-driven oil price shock is exogenous and is estimated to have a significant impact on economic activity. A demand driven shock, on the other hand, is endogenous and basically a result of changes in economic activity. Most oil shocks do not have a straightforward cause, as both supply and demand factors play a role. However, depending on where significant/ structural changes take place, the push can be predominantly from the supply or demand side.
Next we go through the oil price determinants listed above and analyse which one of them have underwent significant changes that are likely to have contributed to the recent oil prices plunge. We then conclude with a forward looking section. In our Special Oil: the good, the bad and the ugly, we analyse the impact of the current drop in oil prices.
 Adv. Ec. = Advanced Economies; EM&DC = Emerging market and developing countries
Economic growth generates stronger demand for inputs such as oil and is, as such, a main driver of oil prices. According to the literature reviewed, the income elasticity of oil demand is fairly high (Breitenfellner et al., 2009; Kaufmann, 2011), meaning that higher GDP growth will lead to higher oil demand. Ever since the 2007/2008 economic crisis, economic growth has been driven by developments in emerging markets, particularly China. This is also reflected in the development of oil demand (figure 3), which has experienced continuous growth on the back of increasing demand from non- industrialized countries. In recent years economic growth rates have seen a positive trend in most parts of the world and so has oil demand. So global economic growth does not explain the fall in prices seen in the second half of 2014.
While global oil demand has been increasing since 1980, oil intensity (defined as oil consumption per USD of GDP) has seen a decreasing trend, even in countries where demand for oil has actually been picking up (figure 4). This development could be the result of efficiency gains, as high oil prices triggered consumers to invest in cost reducing solutions. However, the reduction in oil intensity could also be due to economies diversifying away from sectors that have a high oil consumption rate. Either way, economies worldwide have become less oil intensive over time. However, as this has been an ongoing trend, it cannot explain the recent abrupt fall in oil prices.
Since technology is essential for discovering and exploring oil, the level of technology is probably the most important supply side oil price determinant. Technology in the oil sector has seen major improvements in the past decade, as progress booked on hydraulic fracturing and horizontal drilling rendered the exploration of hydrocarbons in shale layers commercially feasible (oil extracted from shale layers is known as tight oil). This progress was driven by two main factors: 1) the fact that access to low cost oil was difficult as it is mainly located in politically challenging countries and it is mostly owned by governments that administer production and 2) a sustained and historically high level of oil prices since 2000. The fact that the oil industry has invested in developing shale exploration in the US is visible in a marked increase in horizontal drilling activity after the crisis in 2007/ 2008 (figure 5). Therefore data supports a scenario of increased spending on developing new technology during periods of high prices. As technology has made significant advances in oil exploration in recent years, it is highly likely to have contributed to the recent drop in oil prices.
As oil is an exhaustible resource, its price is also a reflection of its scarcity. The level of oil reserves is a basic indicator of oil scarcity and, thereby, an important price driver. However, reserves only influence supply if they are economically recoverable at the current level of technology. The International Energy Agency (IEA) makes a difference between oil resources, which include all oil discoveries, and proven results, which are defined as oil resources that have more than 90% probability of being profitably extracted. The volume of new oil discoveries has been falling since 1960. A small reversal is visible between 2000-2009, which coincides with important developments in the exploration of unconventional oil sources such as shale and tar sands. According to IEA, unconventional oil resources accounted for 55% of all oil resources in 2014, estimated at 6010bn barrels. However, only 28% of total resources were earmarked as proven in 2014, reflecting the huge technological and profitability hindrances related to the exploration of oil. As profitability co-determines the level of proven reserves, periods of increasing oil prices such as 2005-2011 lead to a higher level of additions each year. But there were also several spurts which seem to be driven by technological progress such as in 1986, when oil exploration expanded to Alaska and the North Sea, and 2008-2010 when shale exploration kicked off. One can estimate a proxy for oil scarcity at current levels of technology and prices by calculating for how long current proven reserves can support current consumption (consumption cover, figure 6). In 2013, the consumption cover was 55 years and this level has only been increasing since 1980, when consumption cover was 30 years. The fact that consumption cover has seen some improvements in recent years might have contributed to the recent fall in oil prices, as past scarcity concerns dissipated. But given that this feature has been gradually developing over the course of decades, it does not serve well to explain the sharp price fall in just a few months’ time.
Current production capacity determines the level of potential supply and is the result of past investments. Investments in the oil sector have a long term planning horizon. According to Wurzel et al. (2009), the lag between investment decisions and new production coming on stream ranges between 7 to 10 years. So, the current stock of investments is a function of past oil prices and past expectations about oil price development. As oil prices have been increasing steadily since 2000, bar the crisis in 2007/2008, one would expect investments in production capacity to have picked up as well. Indeed, capital expenditure in the upstream oil sector has been skyrocketing since 2000 (Rabobank IKT, forthcoming) in line with oil price expectations. This has eventually led to significantly higher oil supply, particularly in the US (figure 5). As supply increased faster than demand, this has resulted in oversupply (figure 7), which contributed to the recent fall in oil prices.
Most low cost oil reserves are located in politically challenging countries. 80% of proven reserves are located in OPEC and CIS countries. Therefore, fickle geopolitics pose a significant risk to supply and have repeatedly led to disruptions in the past. The fall in supply from such incidents has increased in recent years. In the first half of 2014 falling output from Libya and increased geopolitical risks in other parts of the world pushed prices up. It also seems that the supply disruptions in recent years, particularly Libya, which used to produce 1.6 million barrels per day(mbpd) before the unrest that started in 2011, coincided with the increase in US supply. Consequently, when Libyan output recovered last summer, the resulting oversupply surprised some and had an impact on oil prices, especially as it coincided with downward revisions to oil demand forecasts.
Market tightness: inventories and spare capacity
A high level of inventories and/or spare production capacity serves as a shock absorber against marked increases in oil demand or sudden supply disruptions. While spare capacity provides some slack on the production side, inventories are in fact precautionary demand. Most OECD countries and China are known to be holding inventories as buffers. As data on the stocks held is fairly scattered, it is difficult to get a picture of global inventory levels, but there is no indication that significant changes took place in recent years, at least none that could justify the recent oil price fall. Spare capacity is usually related to OPEC countries, particularly Saudi Arabia, as the only producer that does not fully use its production capacity. In the past, lower OPEC spare capacity has tended to push prices up as it raised concerns about the capability to react to eventual demand increases or supply disruptions. However, market tightness may have an asymmetric effect in the sense that it poses a more binding constraint when there are upward pressures on oil prices and less so in a situation with downward price pressures.
In the case of the oil sector, market structure is often synonymous to OPEC, which according to some studies has, at times, been acting as a cartel in influencing prices by administering output (Breitenfellner et al., 2009; Wurzel et al., 2009). Saudi Arabia is often called the central bank of oil. As OPEC had committed itself to adjusting supply to keep oil price volatility low and stem any damage to future oil demand, the group of countries was also expected to cut output and stem dramatic drops in oil prices. OPEC’s commitment to intervene, de facto, provided a price floor and a price ceiling (as long as spare capacity was sufficient). According to Fattouh & Mahadeva (2013), Saudi Arabia has increasingly had a signalling role towards market participants since 2008. However, OPEC (under the leadership of Saudi Arabia) decided to defend its market share and did not cut output in response to falling prices in 2014. That basically transformed the market structure towards a more competitive market. This is especially the case since the increase in US oil supply had reduced OPEC’s market share (figure 8), which affected its power to steer the market. It is therefore questionable whether intervention would have had an impact in the first place, but the signalling effect alone may have served as a wakeup call to agents in the market that implicit price collars would no longer maintain.
Exploration costs change with advances in technological development, but also as low cost reserves become scarce and push production towards higher cost fields. Technological developments in recent years have changed the economics of exploration. Shale exploration has a shorter time horizon due to a high extraction rate and lower start-up costs. The lion’s share of oil from a tight-oil well is extracted within 3 years, compared to around 10 years needed for conventional exploration (Economist, 2014). Consequently, tight-oil supply can be more responsive to price increases. However, that is not the case in situations where prices fall and production must be adjusted downwards. While conventional exploration can be put on hold without consequences for the future, shale exploration cannot be interrupted. Namely, tight oil can only be extracted as long as high pressure is maintained on the well. Once interrupted, extraction cannot be resumed. This makes supply less responsive in downward direction in the short term. These changes have had a significant impact on US production of tight oil, which has picked up rapidly in recent years (figure 5). Thus, the change in the economics of exploration was a game changer that contributed to the recent fall in oil prices.
Hedging and speculation
Financial trade also influences prices through several channels. First, financial trade offers oil producers the opportunity to hedge against future oil price declines and therefore makes supply less responsive to price changes for the hedge period. Financial trade also offers an opportunity to take positions in oil and earn money from speculation. However, it is difficult to divide financial trade according to these two purposes as they typically make use of the same financial instruments. As oil-related trading has seen a significant upsurge in recent years, the influence of market expectations on oil price developments has probably also increased. As mentioned earlier, literature does not provide a consensus on whether fundamentals or expectations have a larger impact on oil prices.However, there seems to be a common understanding that market expectations can exacerbate price movements through financial trading. From that perspective, frequent downward revisions of oil demand forecasts and disappointing global economic performance may have had an impact on market expectations and price movements in 2014. However, a closer look at the global oil demand forecast revisions (table 1) indicates that in 2014 they were not large enough to justify the recent fall in oil prices in isolation. Still, also considering slight increases of non-OPEC supply forecasts and bigger downward revisions to economic growth forecasts, it seems likely that all these revisions altered expectations and contributed to the large oil price drop. On top of this, financial trading exacerbated the fall. As hedging activity by oil producers in recent years had picked up, the fall in oil prices in the second half of 2014 pushed their counterparties into the spot market as they were losing on their positions. This increase in trading exacerbated the recent fall in oil prices.
Another oil price determinant is the USD exchange rate. Oil prices are expressed in USD. However, changes in the USD exchange rate are not related to changes in oil’s intrinsic value. So the prices in USD terms adjust to reflect this when the exchange rate changes, ceteris paribus. Literature reviewed also indicates there is a negative relationship between the USD exchange rate and the oil prices (Breitenfellner et al., 2009; Cifarelli and Paladino, 2010). The USD appreciated considerably between June 2014 and January 2015, namely by 15% against the EUR. But the appreciation of the USD was smaller than the fall of the oil price.
All in all, while there have been many factors that contributed to the recent plunge in oil prices, the most significant changes in recent years were on the supply side. Namely, technological developments on the exploration of shale layers led to an upsurge in oil supply and altered factors that have an impact on supply responsiveness to oil price changes. Consequently, we can conclude that the recent fall in oil prices has been mainly supply driven. However, we should also consider the impact of financial trade and the fact that markets overshoot (Breitenfellner et al., 2009). It is therefore uncertain how oil prices will develop further, though they are unlikely to return to last year’s highs anytime soon. What is certain though, is that we can expect a higher degree of volatility (see box 1).
Box 1: It’s raining pigs in the oil sector
The so called ‘pork cycle’ is a known phenomenon in the livestock industry which was first observed in the US pig market. High pig prices led to higher investments in production. However, since pigs take a while to reach slaughter maturity, there is a lag between the time of investment and the time when this additional supply reaches the market. When the latter happens, it usually leads to oversupply and causes pork prices to plunge. The current oil oversupply seems the result of such a development. It also happened in 1986 when high oil prices (maintained high by the OPEC) pushed up exploration investment in the North Sea and Alaska. OPEC eventually intervened and cut output. Nevertheless it took around five years for the prices to recover. The phenomenon is currently not only visible in the oil sector, but also in other commodity sectors with long term investment horizons such as mining. Another aspect of the ‘pig cycle’ is increased volatility. The lag between the change in prices and the change in investments also applies to a downward movement of prices. Thus, lower prices hurt investments. But, since the impact on supply is lagged, it eventually leads to supply shortages and causes prices to recover, in anticipation of which we may interpret the recent pickup in oil prices from the trough at around USD 47/bbl.
Two important fundamental changes should contribute to higher volatility in the future. First, market structure has changed as OPEC’s response to the price fall has changed their role on the market. Consequently, oil prices should be more responsive to supply and demand dynamics. Second, technological advances have changed the economics of exploration. While the shorter planning horizon makes supply more responsive in an upward direction to price increases, that is not the case in a downward direction in the short term, since shale extraction cannot be interrupted. This builds in a lag of up to 3 years for supply to respond to price changes, according to the ‘pork cycle’. This lag is exacerbated by the fact that financial trade in oil products allows producers to hedge against decreases in oil prices. Moreover, as start-up costs are regarded as sunk costs (quite literally actually in a shale oil well) and production companies need to meet (financial) obligations, they will continue to extract oil as long as the marginal extraction costs are covered. This causes a further delay in the short-term reaction of supply to price declines. Both IEA and the US Energy Information Administration (EIA) expect oversupply to persist in 2015, though tightening in the second half (figure 7). However, the lower prices hurt new investments and, thereby, are poised to cause temporary supply shortages in the longer term. This also increases vulnerability to geopolitical risks, which can lead to stronger price adjustments going forward. The recent plunge in oil prices has already led to significant cuts in future investments and is already visible in a fall in drilling activity (figure 5). Such signals that supply might be tightening in the future, backed by IEA statements and downward revisions of supply, altered market expectations and led to an initial recovery in oil prices in February 2014.
The bottom line is that the myriad of uncertainties around future fundamentals of oil supply and demand is expected to increase oil price volatility going forward. Moreover, to the extent that higher uncertainty translates into higher discount rates on exploration and extraction investments, this may hinder supply capacity growth and add to future oil price volatility.
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