Black gold: the focus of attention in 2015

One of the main sources of uncertainty for the world economy throughout 2015 is going to be the trend in oil prices. There are essentially two questions to be answered here: firstly, in what price range will the market find its new equilibrium in the short term? And, secondly, to what extent will this equilibrium last? Or, in other words, is this just a temporary slump in oil prices and they will soon return to their long-term trend, perhaps at their level between 2011 and 2014?

In a few months, the price of crude has fallen by almost half. Although it is true that Europe's frail economy and the slowdown in China may have had some influence, an analysis of the market shows that the fall in prices is due more to supply than demand. The supply of crude oil from countries that are not members of the Organization of the Petroleum Exporting Countries (OPEC) has increased but this has not been accompanied by a reduction in production by the OPEC countries. This is a new situation. On other occasions, OPEC used to try to adjust its supply when other suppliers increased their production, even though this might not always have been achieved due to the difficulty in maintaining discipline among its members. Now, however, it has been OPEC's own leading country, Saudi Arabia, that has declared its intention to maintain its production levels even after the slump in prices. This change in stance has surprised investors, who have quickly adapted their strategies to the new environment and thereby speeded up the adjustment in the price of crude oil. What does Saudi Arabia hope to achieve? How long will it try to keep this strategy going?

One way of attempting to answer such questions is by examining the effect of low prices on different oil producers. The countries most severely affected are those whose public finances and balances of payment become unsustainable when the price falls below 60 dollars a barrel. Low prices also affect the financial viability of much of the new oil supply that has emerged recently, buoyed by prices exceeding 100 dollars a barrel. This supply includes shale oil in the United States but also drilling for crude oil at very deep offshore sites.

With its low price strategy, Saudi Arabia might be attempting to deter (high cost) marginal investment in the industry and thereby preserve OPEC's dominance. Moreover, and without considering geopolitical factors, this policy would also reaffirm the leading role of the Saudi kingdom within its own cartel. It is, undoubtedly, the producer with the greatest capacity to withstand prices at their current level given that it has very low production costs, the largest crude reserves on the planet and a large buffer of international reserves.

Should this interpretation of Saudi's strategy be roughly correct, the period of low prices, i.e. within the range of 60 to 70 dollars, would probably last for several quarters and, once its aims had been achieved and providing the world economy grew significantly, the price would return to higher, more sustainable levels in the medium term, at around 80 or 90 dollars a barrel.

In short, the fall in crude oil prices is unlikely to be permanent but neither is it a temporary phenomenon free from any macroeconomic effect on its own industry. The most probable outcome is that low prices will last long enough to have a positive effect on oil-consuming countries and significant effects on competition within the industry. However, given that oil is still a scarce resource, its price should logically go up again in the medium term and we may even see 100 dollars a barrel again. Consequently we should not give up our policies to save energy and use it more efficiently but, in the meantime, a period of more affordable prices is very welcome in economies that are net importers of oil, such as the euro area whose low growth is causing serious political tensions in many of its member states.

Jordi Gual

Chief Economist

31 December 2014