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Monday / March 27.

Oil Prices – The Engineered Free-Fall

By Ayush Jain

Edited by Nandita Singh

In the last few months, oil prices have fallen by roughly 40%. USA is no longer dependant on imports for oil, for it is now producing nearly 9.2 million barrels a day from shale oil processing activities. These firms started their production at times when oil was around $100-upwards, and with potential of their production increasing, with more emphasis obviously to be laid on more efficient techniques, the output is headed skywards. This involves ‘fracking’ of rocks, the produce of which falls by 60-70% in the second year.

The reducing demand for oil imports in the USA, coupled with a slowing China and EU, has reduced oil demand worldwide. Normally, there would have been a fall in supply, but this hasn’t happened. Saudi Arabia realised that its largest buyer, USA, had a cheaper alternative in the form of shale oil. So, at the recent meet, OPEC, which itself is rife with internal differences, decided not to cut supply to stabilise prices, under pressure from Saudi Arabia. This supply-demand imbalance has led to the free-fall in prices, which, normally, could have been avoided by a reduction in supply.

Will Saudi Arabia’s attempt to fight shale oil producers out of the market by reducing prices succeed, or will it just help in bleeding the poorer member nations of OPEC, while Saudi Arabia sustains with its $900 billion foreign exchange. Shale oil producers are under huge debt, and Saudi Arabia is trying to use this as leverage against such producers. They realise that by cutting prices, they can make these firms struggle to meet costs, and with their burgeoning debt, they will be forced into insolvency. These firms, moreover, currently need investment to make their activities more profitable. These firms currently break even at a price of about $50/barrel, a price where most OPEC nations’ backs would be broken and their ability to sustain themselves, stretched. Saudi Arabia has expressed its willingness to allow prices to fall to even $40/barrel to retain their market share. However, this is not only to fight competition of shale oil producers in USA. Iran has a huge budgetary deficit and needs higher prices of oil to finance its nuclear energy program. Basically, Saudi Arabia had two options, cut output to the benefit of its competitor in the market and its biggest rival in the Middle East, or to keep supply at unchanged to put pressure on the two adversaries.

Now the question is, can shale oil producers sustain such competition. Till prices are about $55-60/barrel, the shale oil producers can still keep themselves at bay. Below that, they cannot sustain themselves and will start reducing investments, leading to falling future output, much to the delight of the OPEC. All eyes are now on OPEC, which continues to call the shots in the crude oil market of the world. A supply cut would strengthen the position of its adversaries. No such cut, and nations like Venezuela and Nigeria would be feel the pressure on their budgets, the deficit of which is usually financed with oil revenues from the exports. Looking at the long run, if prices continue to tumble, OPEC nations would be pressurised, but shale oil producers would find their bottom-line in the negative, and would close shop. These producers cannot sustain reeling losses like OPEC nations, which have huge foreign exchange reserves. OPEC nations realise that shale oil firms, if allowed to grow, would surely become a greater threat later on and thus, have decided to go for the kill right away. They are willing to sacrifice a portion of their profits for the sake of the removal of shale oil producers from the USA, the largest consumer of oil in the world.

Crude oil prices had been around $100/barrel before the impact of the supply glut was felt in the market. Prices would continue to be low over the next few years till the OPEC feels secure about its market share, before stabilising prices. Shale oil could have been the next big thing in the energy sector, but cartelisation ate into what could have been a worldwide phenomenon. It might come back in the future, but the current situation with OPEC nations willing to go to all limits to keep their market share intact, shale oil firms are on the downward spiral for now.