Cheaper oil will bring about much cheer but it will help keep key oil producers happy in years to come
Oil is like a drug that the world economy cannot do without and we are in the midst of a turf war over who will call the shots. A few dealers have had a stranglehold over the market for oil and have been able to set prices as they please. The arrival of new kids on the block (with the rise of fracking in the US) has triggered a fight for control of the oil market. The result has been a plunge in oil prices which is a blessing for the global economy but is part of a bigger strategy to keep us all addicted to oil for years to come.
The sharp drop in oil prices will provide a welcome boost to the economic recovery in many countries. Oil is like a drug in that it is always in demand and buying continued despite high prices in the aftermath of the global financial crisis. Prices for oil have only recently eased off (playing havoc with inflation) as demand from energy-hungry China has weakened while supply from the US has expanded. Oil is also plagued by a further similarity to drugs in that the suppliers of oil tend to be some ugly characters such as Russia, Iran, and Venezuela (as well as some nice ones such as Canada and Norway). But the kingpin of the oil market is Saudi Arabia due to the size of its reserves of oil and its willingness to adjust its output to market conditions.
Saudi Arabia is the top dog of a club called OPEC where some of the major producers of oil banded together to wrestle control of the oil market away from Western energy firms. OPEC came to prominence in the 1970s when the countries cut oil output as a protest against Israel. Along with the devastation wrought due to the resulting surge in oil prices, efforts to conserve energy also acted to weaken the need for oil. Once oil prices returned to normal, OPEC has looked to set its output so as to make the most money while also suppressing incentives to cut back on oil consumption.
Sticking to the optimal level of output was always going to be tricky when cheating would bring in extra cash. This meant that not all members of OPEC stuck to their quotas set to manage the supply of oil and it was left to Saudi Arabia to shoulder the burden of larger cuts to production when required. Saudi Arabia could pull this off due to its revenues from oil being more than enough to fund its government spending. In contrast, governments in countries such as Venezuela and Iran spend big to support their anti-Western antics which tend to max out the cash from their energy sectors.
Trying to stay on top
The arrangements behind this oil cartel have been bust wide open due to the surge in oil output coming out from the US. New fracking technology has unlocked previously inaccessible oil reserves and turned the US into a big player in the oil market. Faced with a choice of cutting its output or suffer falling prices, OPEC chose the latter. The Saudis, in particular, were not willing to take a hit and lose out in terms of market share. As Saudi oil is typically cheap to get out of the ground, their hope is that a lower price for oil will drive others out of business. A drop in oil prices will also scare away any investment in oil fields that would boost output in the future.
It pays for Saudi Arabia to take a long term view of the market seeing that it has so much oil still underground. An abundance of new sources of oil or new technologies that eliminate the need for oil would take a big chunk out of the value of its underground stash. Saudi Arabia is in a strong enough position to sacrifice short-term gain to lock in future control over the oil market. Be thankful that the Saudis want oil to be cheap for now and keep us all addicted but don’t expect it to last (much more than a few years).