Cure for Low Oil Prices

There are plenty of global economic indicators suggesting that the global economy is growing, and benefitting, on balance, from the drop in commodity prices. Global oil demand is up close to 2.0 million barrels a day or 2% growth the fastest pace in 20 years. Lower oil prices gives an incentive for higher demand. The world still needs massive amounts of oil. And when prices fall, the world is likely to use more of it. Demand expectations are rising, not only for the rest of this year but next year and beyond. Instead of China leading the way the biggest demand growth will instead come from by a rapidly growing India.

But lower oil prices are almost definitely bad news for the governments whose budgets are dependent on them being high: Saudi Arabia, ostensibly the leader of OPEC, is facing huge budget deficits this year due to decreased oil prices. According to the International Monetary Fund (IMF), the deficit will be about $140 billion or 20 percent of its GDP. Canada’s economy has also made headlines as low crude oil prices meant that the Canuck GDP shrunk for first half of 2015. Major oil-producing countries—that list includes Venezuela, Libya, Russia, Qatar, and Iraq—are all taking a hit.

Prices of OPEC’s benchmark crude oil have fallen about 50 percent since the organization declined to cut production at a OPEC 2014 meeting in Vienna. Iran, Venezuela and Algeria have been pressing the cartel to cut production to firm up prices, but Saudi Arabia, the United Arab Emirates and other gulf allies are refusing to do so. Saudi officials have said that if they cut production and prices go up, they will lose market share and merely benefit their competitors. They say they are willing to see oil prices go much lower.

The oil market is oversupplied, prices are low and producers are fighting to undercut one another to hang onto market share. The global investment in exploration and production has fallen from $700 billion last year to $550 billion this year. With prices remaining low, the declines that started earlier this year are only expected to continue in 2016. In fact, U.S. oil production is now predicted to slide by 400,000 barrels per day next year, which is the biggest drop since 1989. That decline is expected to be a key part of putting the crude oil market back into balance.

In theory low commodity prices should result in lower supply, or at least a slowdown in growth as commodity producers find it uneconomical to keep a mine or an oil well producing. In reality though it can take quite a long time for consumers and producers to react to pricing signals with demand and supply for commodities very price inelastic. At some point, Economics 101 dictates that low prices will eventually cure low prices.

As production is declining, demand for oil is starting to accelerate. According to the International Energy Agency, demand for oil is growing at the fastest pace in five years as low oil prices spur demand for more crude. The IEA sees demand for oil rising by 1.6 million barrels a day this year, the fastest pace in five years. Meanwhile, it sees demand rising by another 1.4 million barrels next year. That’s 3 million barrels a day of incremental demand for an oil market that at its peak was oversupplied by around 2 million barrels a day. Given the outlook for falling production in the U.S. over the next year, there’s reason to believe that crude prices could rebound.