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Tumbling Of Crude Oil Costs: Economic Laws Say That This Is A Short-term Phenomenon

By W.A. Wijewardena

Dr. W.A. Wijewardena

Dr. W.A. Wijewardena

A drastic reduction in crude oil rates

Crude oil rates in the planet marketplace have tumbled and they are nevertheless tumbling. The average price of the West Texas Intermediate category of crude oil stood at a level of $ 100 per barrel, which is equal to 159 litres a handful of months ago. It has now fallen to a level of $ 60 per barrel final week. This is practically a decline of 40% in an important commodity within a couple of months.

Supply has grown quicker than demand causing prices to fall.

The price of any commodity falls mainly due to that commodity getting an excess provide. An excess supply can occur due to a fall in demand or an boost in provide or both. In the present predicament, when the Northern Hemisphere of the globe goes into winter, the demand for oil merchandise usually rises simply because of the require for heating. Hence, if there is an excess supply this winter, it is primarily due to the supply of crude oil increasing faster than the improve in demand.

Two theories have been raised to explain the present excess supply of crude oil in the marketplace. One is financial and the other is political.

The US going into tapping shale oil sources

The economic motives are significantly less unknown in this part of the world. That is, the United States has, in a massive way, explored oil in new oilfields recognized as ‘shale oil’ fields by utilizing a new technology referred to as ‘fracking’ which is the shortened kind of what is ordinarily referred to as ‘fracturing’.

Oil shale refers to a rock situated about 4-5 km beneath the surface of the earth containing solid bituminous components referred to as kerogen that are released as petroleum-like liquids by heating the rocks (accessible right here) The shale oil is in strong form and for that reason can’t be pumped to the ground like the oil that is extracted from conventional oil fields. Hence, even although the availability of oil in shale rocks was known for centuries, the industrial exploitation of shale oil did not take spot until the early component of the second decade of the new millennium.

Even as late as 2011, the US Bureau of Land Management had concluded that “there are no economically-viable ways but identified to extract and process shale oil for commercial purposes.”

The fracking technology to bring shale oil up

But this was not to be for extended. A new technique of tapping the vast deposits of oil and gas contained in shale rocks was employed on a industrial basis in the US right after about 2012. That was called hydraulic fracturing or merely ‘fracking’.

With this approach, what is becoming done is that a vertical hole is drilled up to the formation of shale rocks, which are located about four km beneath the ground level. This vertical drill is continued horizontally via the shale rock related to the ‘donas’ which a single finds in gem pits in Ratnapura. Then, about 4 million litres of water mixed with sand and chemical compounds are injected at higher stress to the horizontal section of the drill causing the shale rock to fracture and crack open, similar to the fracturing which could happen in a bone of the physique when it is subjected to a heavy blow.

The fissures developed by the fracturing are kept open by the sand that is released along with the water mixture. It causes the shale rock to release the gas and oil which had been contained within it for a lot of millions of years. The oil and gas mixed with water are then pumped back to the ground, separated and employed for further processing. The recovered water is initial stored in open pits and then removed to treatment plants.

The fracking revolution

Fracking has revolutionised oil and gas exploration in the world. This was hitherto a commercially untapped resource and now it is getting tapped on a huge scale, especially in the northern portion of the United States.

Its sudden proliferation has helped the United States to increase production of each these energy things. By 2014, the US became self-adequate in natural gas and in the case of oil, emerged as the world’s biggest producer of crude oil, driving Saudi Arabia down to second spot.

It is estimated that by 2020 the US will grow to be self-enough in crude oil as effectively. This was excellent news for Obama administration which had been beleaguered by all for a lack of visible financial recovery in the country. Hence, despite the protests against fracking on environmental grounds, the Obama administration is openly supporting the new oil exploration venture which US companies have undertaken.

The world’s fracking mania

Shale oil is not confined only to the US. It is abundantly accessible in the southern provinces of Canada, Lithuania, China and New Zealand. Soon after it was proved that fracking technology was a industrial good results, all these countries have now started plans to exploit their shale oil resources. The enhanced oil and gas production in the US has decreased its imports making a glut in the present power marketplace, sending prices down.

Planned future shale oil exploration by other nations will hold the market place glut going for numerous a lot more years. The present surplus as effectively as the anticipated surplus has sent oil costs tumbling in the globe industry. That is the economic cause for the present decline in oil prices.

A conspiracy theory to clarify falling oil rates

The political cause is connected with a well-liked ‘conspiracy theory’. The present glut has been augmented by Saudi Arabia’s refusal to reduce oil production to match the decreased import demand to sustain oil prices at its historical typical of $ one hundred a barrel.

The Saudis have rationalised that even if oil prices have come down to $ 40 a barrel, they would nevertheless not take into account cutting oil production. The present low oil costs are a loss to Saudis and other members of the Organisation for Petroleum Exporting Countries, popularly recognized as OPEC. But if costs further tumble to a $ 40 level, their losses would be augmented beyond recovery.

In this background, what has prompted the Saudis to stubbornly refuse to reduce oil production? The conspiracy theory has been harboured to justify this irrational behaviour.

Bringing Russia to its knees

It has been argued that the Saudis want to punish 3 parties by permitting oil costs to fall in the market place. First, it is to punish Russia which is supporting the Assad regime in Syria which the Saudis want to topple. Russia is heavily dependent on its oil sources for financing the price range and earning foreign exchange. About a half of its budgetary revenue and about 60% of its export earnings come from the oil sector. When these earnings dwindle on best of the present financial sanctions against Russia by the US and the EU on account of its expansionary policy toward Ukraine, Russia is anticipated to fall to its knees, completely appreciating the emerging stark economic realities.

Currently Russia has been punished by these two counts: its currency, the rouble, has fallen in the marketplace from about 30 roubles a dollar to 70 roubles a dollar. The Russian Central Bank is desperately trying to maintain the rouble from further falling by releasing some of the dollar reserves it is holding and escalating interest rates to an unprecedentedly high level of 17% per annum. Each these measures are anticipated to punish Russia in the long run by shrinking its economy.

Punishing Iran for getting nuclear ambitions

The second celebration which it is claimed that the Saudis want to punish is the unfriendly regime in Iran. Iran’s nuclear ambitions have been deemed by the Saudis as a threat to their existence. Since it is unlikely that Western sanctions against Iran could force the regime to abandon its nuclear ambitions, it is said that the Saudis want to make their own attempt. That is, by forcing oil prices to fall in the market place and sustaining them at those low levels for sometime the Saudis want to provide a fatal blow to that nation.

Damn the US shale producers

The third party to be punished, according to this conspiracy theory, are the shale oil makers in the US. Tapping shale oil resources is a costly affair and if oil prices fall beneath $ 80 per barrel, offered the current expense structure, the boom in the shale oil sector in the US will come to a sudden finish. Thus, it is alleged that the Saudis want to get rid of a single of their rivals who has resorted to option oil exploration.

Can the Saudis be on a self-destructive path?

This conspiracy theory is rationalised by pointing to the low expense of the production of crude oil in Saudi Arabia. Because Saudi oil is found pretty close to the surface level, it is blessed with the lowest expense among all the oil producers in the planet.

Its charges range in between $ 15 and $ 25 per barrel whereas in all other nations they are above 50 per barrel. So, the Saudis can still survive even at a price tag of $ 40 per barrel whereas all other producers, including the US’s shale oil producers, will vanish from the industry at that value level.

It is economics and not conspiracies which rules markets

Several believe in this conspiracy theory due to the fact it is exciting and attractive to the well-liked sentiments of people. It is the big and potent guys who are to be punished and not the poor nations in the world. Hence, a conspiracy theory which suggests that the US is going to be punished has considerably a lot more appeal than any other conspiracy theory.

But if this conspiracy theory is true, then, the Saudis are on a self-destruction path. Saudi Arabia depends principally on its oil sector for wealth, export earnings and prosperity. If oil prices are at a low level for a considerable period of time, it is Saudi Arabia which is to endure more than these countries which it desires to punish. Additional, though the Saudis can withstand and survive through a cost reduction, all other members of OPEC can’t do so due to the higher price of oil production by them. A lot of such producers, especially Venezuela and Nigeria, have to close shop if they are hit by such an external oil value shock.

It is as a result unlikely that any rational selection-maker would go for such a self-destructive choice. Hence, it is more probably that these punishments are basically a natural consequence of the present global oversupply in oil rather than deliberate action taken by 1 of the major oil producers.

Market’s reaction to low oil rates

Hence, the all-natural industry forces will do a series of market adjustments to right the present fall in oil rates. Pressure would be exerted on Saudi Arabia to cut output and thereby bring oil prices up once more. Investors in shale oil in the US, obtaining that their oil wells are no far more economical, will voluntarily restrict oil production thereby permitting oil imports to the US as soon as once again.

These nations which are blessed with shale oil deposits will postpone their plans to tap this resource thereby taking out the anticipated market place provide of crude oil due to new shale oil exploration. Accordingly, marketplace costs will start moving up once once again and get stabilised at around $ 80 to $ 90 per barrel. That cost is an economic value for all other oil producers in the globe.

Low oil rates are an inhibiter to Sri Lanka’s Mannar Basis ambitions

Sri Lanka’s existing oil consumption stands at about 1 billion litres of petrol and two billion litres of diesel per annum. It would have gained a substantial advantage due to the low oil rates had it not enhanced its vehicle imports in a massive measure in the current past via a supporting duty reduction.

Vehicle registrations are increasing at a rate demanding a lot more oil and diesel imports. Accordingly, though the price is low, the volume will improve, decreasing the total advantage which the nation would have gotten out of the decline in oil rates in the planet market.

Sri Lanka’s nascent oil exploration efforts in the Mannar Basin will also suffer if oil rates are at a level of $ 80 or beneath. These offshore oil explorations are such a pricey affair, even North Sea oil producers cannot survive unless oil rates have risen to a level of $ 90 and above.

If the prices are reduced than this threshold value, the Mannar Basin oil could be pumped up only with a supporting subsidy by the Government. Hence, it will be a lot more economical for Sri Lanka to hold the oil under the sea level in the Mannar Basin alternatively of taking it out.

The current value fall is a temporary phenomenon

Consequently according to economic logic, the present tumble of oil rates in the globe markets is going to be a short-term phenomenon. They will stay at these low levels only for another six to eight months. Soon after that, prices will settle when again at a level of about $ 80- $ 90 a barrel.

*W.A Wijewardena, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at [email protected]

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