Will the price of oil be lower for only a little bit longer?

Will the price of oil be lower for only a little bit longer?
2018-01-04

Most of the other opinion pieces that discuss the price of oil around this time of the year reflect on what happened in 2017 and try to predict what will possibly happen in 2018. This opinion piece written by Dr Marc Grownwald, Senior Lecturer in Economics at the University of Aberdeen Business School, looks back a little bit further, but also looks further into the future. Thus, rather than dealing with the short-run, the focus here is more the medium-run.

There are certainly some noteworthy short-term developments. The OPEC cuts deal seems to work; in response oil prices jumped over $60, rumors have it that this deal will be extended. An influence will also have the restart of refineries in the US gulf.

Whether or not oil prices are going to be “lower for longer”, however, is unlikely to be determined by these types of short-run events. One never knows what OPEC is going to do; and there are always other types of unexpected events. The main driver of prices in the near future, perhaps not next year, but the medium-run, is related to the reaction of the industry to the oil price slump witnessed back in 2014: the dramatic cut of exploration budgets. Admittedly, oil price declines like this one are essentially unprecedented. Thus, both the oil industry and economists, like myself, have to understand what is going on and what the consequences this will have. However some effects we observe already: the level of new oil discoveries is very low. This comes on top of the observation that the majority of recent discoveries are not as large as they used to be.

It is generally striking that there is this strong pro-cyclicality; if oil prices are high, there is a drilling boom, accompanied by an increase in drilling cost; now prices are low and drilling activity is low. It is certainly difficult to predict when this decline in discoveries will have an effect on global production; perhaps in 10 years, maybe earlier, maybe a bit later. To what extent a possible decline in production will affect oil prices certainly is also determined by demand. For 2018 projections seem to be optimistic, but certainly the future is uncertain and, ultimately, major global developments will determine future global demand. To a certain extent oil prices are also driven by expectation; thus, when will market participants understand what is going on and how will they respond?

It seems to be the case that there is an interesting feedback loop: drilling is high when the price is high, with higher future supply as consequence. Low prices have the effect just described. It certainly is also possible that this loop always existed but now it is more pronounced and results in larger oil price fluctuations. James Hamilton, economist at University of California at San Diego, said about the increase in the 2000s that this is one of the main drivers by unexpected increases in demand in combination with the inability of production to increase. Today tight oil producers are a new factor not present 10 years ago, but it cannot be ruled out that history repeats itself: perhaps oil prices are going to be lower only for a little bit longer.

https://www.abdn.ac.uk/business/people/profiles/mgronwald

Published by Business School, University of Aberdeen

Comments

  1. #1
    Scott Pittendrigh

    Hello

    I wish I would have read this article sooner. Although tight oil production has increase the United State's and even Canada's national oil supply, there are a number of problems with it. Much of the tight oil supply in the US and Canada relies on debt-financing that remains restricted by revenue-based covenants. In many way it can be argued that the real price of oil, U.S. dollar, and U.S. real interest rates.

    It may be that real exchange rate shocks are an important determinant of real oil prices. Fluctuations in the U.S. real interest rate may and probably have quantitatively important effects on the real price of oil. Changes to the U.S. real interest rate have important effects on the real exchange rate. I am deeply skeptical that this goes the other way.

    The extent to which market participants comprehend this is an interesting empirical question. I am not sure that comprehending crowd is in the majority.

    Great article




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