Why Oil Prices Are Dropping

Oil prices have declined some 50% in the past few weeks after OPEC made it clear that they will continue to produce at current rates despite the market being oversupplied.  Some OPEC ministers have even said that $40 per barrel oil might be tolerated.

This tolerance for dramatically lower oil prices is not unprecedented.  Oil prices declined to $11 per barrel in 1986, led by Saudi Arabia increasing their output.  This was intended to counter and reduce the pace of North Sea oil developments.  This time, Saudi Arabia is trying to counter the US shale oil success story which has added 1 million barrels per day for each of the last three years.   I also think that there is some credence to the idea that Saudi Arabia and the US have colluded to punish Russia for their military action in the Ukraine.  And it's working!  Russia's currency is collapsing despite 17% interest rates.  A full-fledged crisis in Russia is brewing. 

Here's a chart showing the rise of US oil production in recent years:

 

Production in the US is on track to reach 9 million barrels per day by the end of 2014.

The Supply and Demand Picture for Oil

Increasing demand causes oil prices to rise, which in turn stimulates additional supplies.  This process is shown in the following graph showing what happened during the period 2004 to 2008 when oil hit $140 per barrel. Demand rose and prices rose sharply:

This year, worldwide demand has slightly declined while supplies (mainly from the US) rose.  Due to the shape of the supply curve, the equilibrium price has fallen dramatically.  The dotted supply curve is for the year 1994. The supply curve for 2014 is shown as solid blue. Much of that extra supply is from the US.  But demand has been slightly declining since China has slowed.   See the following chart:

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For prices to go back up, demand has to increase and/or supply must contract.  Oil prices of $50 will crimp marginal shale oil production and Canadian oil sand growth but absolute drops of production volumes will occur but will be slow to materialize.  Lower oil prices will marginally stimulate demand in the short and long term.  If the world goes into recession, then demand and prices will fall further.