Birth of the Industry
Oil industry has been governing the world politics for the better part of 20th century. It all started when a crazy retired railway man called Cornel Drake was hired to drill one of the first oil exploration wells. Using some old Chinese methods he and his workers started to drill a well in Pennsylvania, USA. After days of slow and difficult drilling without any results the investors gave up. A letter was send to Drake to close down the operations. Thanks to the slow postal system, on August 27 1859, the day the letter reached, Drake had already seen the first drops of oil rising through the borehole. News spread rapidly leading to the mad rush for black gold. Widespread uncontrolled drilling led rapid increase in oil production and resulting decreasing in oil price making Drake’s well uneconomic. Drake died a poor man after kick starting one of the most powerful industries of the world. Oil Industry made many people rich, and probably the richest of them all was John D. Rockefeller. Rockefeller was a shrewd and cleaver businessman under whom Standard Oil Company gained monopoly over the oil business. Since then the industry has never looked back. The power of the industry was realized during the World Wars, where it played a key role in deciding the outcome of the deadliest battles in history.
Change of Power
The geo-politics of oil took a decisive turn on 3 March 1938 when the first oil discovery was made in Saudi Arabia. It was followed by plenty of discoveries in Middle East, including Ghawar, the largest conventional oil field. Saudi Arabia had the largest oil reserves until Venezuela crossed them in 2011. Most of these fields are very cheap to produce. The government of the oil producing countries realized the importance of oil and the nuisance of the industry that was so far governed by few major oil companies. All the non-Arab and Arab countries including Saudi Arabia joined hands to form OPEC on 1960 to secure the best price of oil available by controlling production. The power of OPEC was first realized on 1973 when they declared oil embargo on Western countries supporting Israel in Yom Kippur War. It resulted in increasing in oil price by four times from 3USD/bbl to 12USD/ bbl affecting the economies of oil importing countries like US pushing the later towards recession.
The Fall and Rise
The rise in oil price led to decrease in demand in the importing countries. This, along with increase in oil production from non-OPEC countries, especially USSR, led to the fall of oil price in the 1980s. Saudi Arabia did try to reduce its production to increase the price, but it did not help. Then they started to produce more instead, dropping the oil price further down to a level where fields with costly production cost could not sustain. The country worst affected by it was USSR and many of its oil fields were shut down. The fall of USSR marked the end of cold war. The oil prices remained low until the turn of the century when the increasing demand of the developing countries like China drove the oil price up. The rise was helped by the decrease in oil production from Iraq after it was invaded in 2003. The big American oil companies were smiling. By 2005 crude oil reached 50 USD/ bbl. The increase in oil price was maintained by controlled production in OPEC countries until the recession of 2008. The oil price started to increase again on the backdrop of political turmoil in Middle-East.
Why High Oil Price Good?
High oil price hurts the consumers, and low price comes as a relief for them. Decrease in oil price transfers the profits from the oil exporting countries to the oil importing countries. Low oil price, however, is going to hurt the oil industry and thus the millions of people working for them.The upside of the high oil price is that the oil companies can be more aggressive and take more risks in exploration adding new fields. It also makes many marginal fields economic. Deep-water prospects that are costly to operate or tight un-conventional reservoirs that are costly to produce add to a huge amount of natural resource. One of the revolutions that came out of high oil price is the Shale Gas. Shale Gas provides jobs over 600,000 people in US alone. In US, for long the largest importer of oil, shale gas production has dramatically increased in the last five years bringing US close to becoming a net exporter.
Why is the Oil Price Falling?
Since 2011 China’s growth rate started to decline slowing down their demand for oil. The demands in Japan and many European countries are slow to rise due to weak economy. This has been coupled with the increase in production from the unconventional reserves in US and Canada. Oil prices started to fall from September 2014 as rising oil supply outpaced the slowly rising demand. Oil prices have always been volatile, and the sharp drop of 2014 is nothing new. Most experts say that the price will stay low for a couple of years, but nobody can predict with any confidence how long the price will stay low, or how much it fall.
Like always, conspiracy theories about why the oil price fell have flooded the market.
THEORY 1: US and Saudi Arabia has joined hands to keep the oil price low in order to hurt ISIS. ISIS controls numerous oil fields, the profit from which is used to buy arms. Lower oil price will weaken the terrorists.
THEORY 2: Again it is US and Saudi Arabia who together wants the price to be low to hurt Russia and Putin. There is a renewed cold war after what happened in Syria and Ukraine, and just like the 80’s, low oil price will lead to fall of Russia. The cost of oil production in Russia is high and their industry cannot sustain at low oil prices.As an additional benefit Russia will no more be able to compete with Saudi Arabia in the oil market.
THEORY 3: US have been the biggest customer of Saudi Arabian oil. With the rise of shale gas US is inching toward self-dependency. Not something Saudi Arabia likes. Hence they want the price to be low enough to kill the shale gas companies and regain its monopoly over the oil market.
Effect of the Falling Price
Russia and Venezuela, two of the largest oil producers, has been worst hit by the plummet of oil price. Both countries are sliding into deep recession. It will also affect other oil exporting countries like Nigeria and Iran. Saudi Arabia, with its cheap oil production cost can keep making profit at low oil prices. However, the low oil price will definitely reduce their profit, and may have some effect on their economy as they depend heavily on the oil money. They can cut production to bring the oil price back up, but like in the 80’s, it might not have much effect. Instead they will lose their market share, and the gap will be filled in its competitors. What it hopes instead is that the oil price will rise once more when its competitors like Russia, Venezuela, US and Canada run out of business. Shale gas industry, especially in US and Canada, will definitely be hurt if oil price keeps falling, and stays low. The low oil price will however benefit the people of US who are the largest consumers of oil. Oil importing countries like India, Turkey, Indonesia, China, and some countries of Europe will also benefit from the low oil price.
What India Gains?
India, the fourth largest consumer in the world, imports almost 80% of its oil. The low oil price will reduce the trade deficit (import-export). “For a country like India, it is really an opportunity to use this window of low oil prices to put in fiscal consolidation, to put in other kinds of reforms and to get growth back up," said Kaushik Basu, Senior Vice President and Chief Economist of the World Bank. India spends a lot of money on oil subsidy and the falling oil price is an opportunity to reduce the subsidy. If the oil price does not bound back quickly, the profit from the reduction in subsidy will reduce financial deficit (what government earns-what government spends), and thus lower inflation. That will help in the growth of India’s economy. On the flip-side however, the oil price will affect economies of countries like Russia and Middle East, which imports goods from India. The slowdown of the economy may affect India’s exports hurting India’s economy. Neelkanth Mishra warns: "Further, capital flows get impacted, too - if you look at the sources of funds that invest in India, it's primarily the sovereign wealth funds (SWFs), the pension funds and the insurance funds. If Norway, Saudi Arabia, Abu Dhabi, Qatar, or Kuwait are not going to see the kind of surpluses that they used to then they will have less capital to send out, which will mean that capital flows into India will not be as strong as they were." There is a complex relationship between the costs and benefits of the oil price and only time will tell how much it helps India’s economy.
To conclude, oil price has always been volatile and unpredictable. There is a complex inter-dependency of supply and demand. Lack of supply and rise in price will increase exploration bringing costly fields under production. This will increase the production resulting in drop of oil price. The drop will make costly field uneconomic thus decreasing the production, and the oil price will bounce back. When and by how much? That is anybody’s guess. Let's wait and watch. As for those of us in the oil industry, we can only pray that the oil price does not fall too much.