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Energy Insights: Energy News: A simple guide to the sudden collapse in oil prices

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A simple guide to the sudden collapse in oil prices



The news in the markets is dramatic: Prices for West Texas Intermediate crude oil -- often used as a benchmark of U.S. prices -- dropped below $70 per barrel for the first time since 2010. This continues a dramatic price slump for oil, which cost over $100 per barrel as recently as June.

The shift has markedly reduced average U.S. gasoline prices (which are now well below $3 per gallon) and may bolster the U.S. economy heading into the Christmas spending season -- by putting considerably more money in consumers' wallets.

But what's driving this slump -- which is quickly becoming the single most important economic story of 2014 (and maybe 2015)? There's one short-term reason and three longer-term reasons.

The most immediate reason is that the Organization of the Petroleum Exporting Countries -- a  group of 12 nations including Saudi Arabia, Iran and Venezuela that holds enormous power over global energy markets, producing 40 percent of global oil supply  --  decided on Thursday not to cut production at their meeting in Vienna.

The meeting was the most important in years, because it came amid a pre-existing slump in prices. Everybody wanted to know if OPEC would take any action to halt the decline. It didn't -- presumably because its members decided it was wiser to weather the current storm -- and crude oil prices immediately tanked.

The long term reasons include booming U.S. and world oil production, little demand in Europe and Japan, and improving automobile fuel efficiency standards.

1) Booming U.S. and world oil production. Even as OPEC kept production steady, it has been growing elsewhere. The United States, most of all, has seen a major growth in oil production, thanks to the shale oil revolution, in which new technologies like horizontal drilling have allowed access to hydrocarbons deep beneath the Earth's surface.

The figures from the Energy Information Administration are truly dramatic: Almost twice as many barrels a day of crude oil are being produced now in the U.S., versus the mid-2000s:

Production of oil has also been up in many other countries. Canada increased its crude oil production from just over 2.5 million barrels per day in 2009 to over 3.3 million in 2013, and Russia increased from about 9.5 million barrels per day in 2009 to over 10 million barrels per day over the same time period. Libya, meanwhile, is bouncing back after production tanked in 2011 due to the country's civil war.

In sum, there's just more oil out there for people to buy, which is having a predictable effect on prices, pushing them downward.

2. Little demand in many regions including Japan and Europe. There's also the fact that while the U.S. has recovered steadily from the Great Recession, many other countries have not. They're struggling, and that is dampening oil demand.

In Europe, for instance, while total petroleum consumption averaged over 15.3 million barrels per day in 2009, it was under 14.3 million in 2013, and has dropped further since.

There's a similar story to be told about Japan:

3. Strides in vehicle fuel efficiency. In the U.S., we're also using less fuel in our cars because those cars are more efficient. The sales-weighted fuel economy of vehicles in the U.S. increased from 20.8 miles per gallon in 2008 to 25.3 miles per gallon in 2014.

Here's a figure from the Energy Information Administration that captures the trend:

So in sum, it would seem that the trend in oil prices is  due to that most basic of economic factors: Supply and demand.

So what happens next?

Does the slump continue, or is it possible we've already overshot and are due for a reversal in oil prices? We can't be sure, but there are some reasons to think a bounceback could be possible, especially if there's a European economic recovery. And in the long term, overall fuel consumption is definitely projected to increase, not decline, out towards 2040 -- driven largely by demand in developing nations.

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