Over the last year and a half, oil prices have plummeted. In July 2014, Brent crude oil, considered a market benchmark, cost about $115 per barrel. Currently, it costs just under $37.
We’ll explain the reasons behind this sharp drop in oil prices as well as the impact it has had both on the the global economy and our domestic economy, including the ways in which you can benefit.
Why have prices dropped? And will they stay low?
As with almost any other commodity, prices for oil are based on supply and demand. Lately, supplies have been increasing, while demand has been falling. This has caused prices to drop.
But the story doesn’t stop there.
Unlike many other commodities, the supply of oil can be, and is, carefully controlled precisely to keep prices in check.
The Organisation of Petroleum Exporting Countries, or OPEC, is a cartel of oil producing countries who collectively meet and set production targets (either increasing or decreasing current levels) in order to directly control the global price of crude oil.
Given that most of these countries rely on oil exports for the bulk of their income, it is often in their interest to limit production whenever prices fall too much, thus reducing the available supply and pushing prices back up.
As long as OPEC control a big enough share of the oil market, then prices are essentially under their control. Recently, however, their control of the oil market, and the wider energy market, has been threatened by, for example, countries like the US producing and exporting shale gas through fracking.
So, when OPEC countries met recently to discuss what course of action they should take in light of plummeting prices, they failed to fully reach an agreement, given the conflict of imperatives – keeping prices high to help their economies in the immediate term, and keeping prices low so that export levels remain high enough for OPEC to maintain a large market share.
In the end, production was not limited and in fact, in November, it was reported that OPEC had increased their production to 31.7 million barrels a day; exceeding the initially proposed maximum of 30 million per day.
Indeed, in a report published recently by OPEC, they said that prices per barrel are unlikely to exceed $100 until at least 2040. The report did maintain that prices would be going up, but very slowly, going “from more than $70/b in 2020 to $95/b in 2040”. These figures, however, are based on 2014 dollar prices, and so adjusted for inflation, the nominal price per barrel in 2040 is more likely to be closer to $160.
Goldman Sachs have predicted that prices are likely to fall even further than they have already, reaching $20 per barrel in the not too distant future, forecasting OPEC’s production to exceed 32 million barrels per day.
Effects on the global economy
While, on the surface of it, it would seem as though countries that rely on oil exports for most of their income are likely to be the worst affected by falling prices, the above political narrative involving OPEC tells a slightly different story.
Wealthier OPEC members, Saudi Arabia in particular, have the capacity to sacrifice some short term income in order to maintain a stranglehold on the oil market and push out higher-cost producers like the US and Russia (who, despite being the world’s largest individual oil producer, are not a member of OPEC).
As one reporter at Business Insider put it:
“All year, oil-producing countries have been in a mad race to the bottom. Russia and the US (and a bunch of other countries) refuse to cooperate with OPEC to keep prices high, so Saudi Arabia and OPEC have been furiously pumping cheap, competitively priced oil.”
Producing 544 megatons of oil a year, Russia are the world’s largest producer of the fossil fuel (beating Saudi Arabia by just 24 megatons). However, against the weight of all 12 OPEC nations, they do not have the capacity to produce cheaply enough to properly compete.
It is not entirely clear though how effective this strategy of OPEC’s is.
US produced natural shale gas is a direct competitor and a direct reason for OPEC’s decision to keep production high. However, US production and export of shale gas has barely shrunk, implying that pressure from OPEC, and the Saudis in particular, is not having the desired effect, or at least not as much as they might hope.
Further, some OPEC countries themselves are likely to fund themselves bearing the brunt of the decision. Venezuela, for example, for whom oil amounts to 90% of the country’s total exports, is unlikely to be able to weather this particular storm if it carries on for too long.
Really, those who are going to come off best from plummeting prices are countries like China who rely on imports for their energy.
Interestingly, it was the economic crash in China (that followed the de-pegging of their currency early this year), reducing the country’s ability to import on such a large scale, that shrunk global demand for oil and had a not unimportant effect on prices dropping in the first place.
India, who import around three quarters of their oil, are also likely to benefit from the current situation.
Effects on our economy at home
Domestically, and at least in the short term, low oil prices are having a fairly positive effect on our economy.
Low oil costs were cited as one of the most important factors in keeping CPI inflation low (at 0.1%) for the time being. This means that the news is likely to be welcomed by borrowers, who can enjoy the fact that low inflation means less pressure on the Bank of England to increase interest rates, meaning that – for now at least – rates on loans will be fairly low.
Consultancy and accountancy firm PwC are claiming that if oil prices remain low – not exceeding $50 per barrel – then our economy is likely to enjoy growth of around 1% each year. This could translate into the creation of around 105,000 jobs, not to mention the effect it will have on general spending, as customers can enjoy getting more for their money as goods don’t go up in price.
Despite losing money from what would be made from sale of North Sea oil, our government here in the UK will undercut that loss and actually make more from the taxation of additional income from new jobs than it would lose.
How does this all translate to prices at the pumps?
Now for the important bit. Just how do plummeting wholesale costs of crude oil translate into savings for you, the customer?
Unfortunately, while falling prices per barrel do mean falling prices at the pumps, we’re unlikely to see prices for petrol and diesel fall to as low as they were last time Brent crude dropped to $37 per barrel.
This was back in 2004, when prices at the pump for petrol and diesel were 79p and 80p per litre respectively. Today, with Brent crude prices at the same level, petrol and diesel cost 102p and 106p respectively.
Aside from inflation, there is a very big reason why cheap crude does not mean that petrol and diesel will be comparatively as cheap.
On average, around 62% of the cost of a litre of fuel for your car is made up of taxes. The government makes a minimum of 57.95p in fuel duties from each litre sold, and that is before VAT is charged, at the standard rate of 20%.
But despite the fact that petrol now costs an around 20% more than it did a decade ago (which isn’t so bad when you think about it), we’ve seen prices fall comfortably for consumers as they have for wholesale crude oil.
To make it worse, diesel users are getting the shortest straw since, wholesale, it is cheaper than petrol, but in the forecourts, the reverse is true.
Unfortunately, according to data from Ernst and Young, savings made on fuel are likely to be undercut by increases in car insurance premiums, which are set to increase by an average of 8% in 2016.
