The global price of oil is often thought to have a certain mystique. Many assume that hidden forces, conspiring governments, and cartels move the price up and down in order to achieve various geopolitical goals and financial gains. However, what actually moves the oil price up and down is pretty simple: supply and demand. The current dramatic drop in the oil price, which began in the summer of 2014 and brought the price down by half in six months, resulted from a number of factors that increased supplies and brought down demand. The decrease in demand can be traced back to declining economic growth in China, the recession in Japan, economic downturns in Germany and other parts of Europe, and increased energy efficiency in the United States and Europe. Conversely, the increase in supply was caused by the unanticipated and dramatic increase in U.S. and Canadian oil production, the increase in oil production from Russia in recent years and the ability of producers such as Iraq and Libya to maintain output despite political instability. How do current misconceptions of the factors behind oil price differ from reality, and what does this say about the future of the global oil market?
First, it should be noted that as oil is traded globally at a single price, albeit with small adjustments for transportation costs and oil type. Thus, major changes in oil supply or demand in one part of the world change oil prices around the globe. Most oil is traded on spot markets between commercial entities with little or no government involvement. One reason for the apparent mystique of oil prices is their frequent volatility. Indeed, oil has the most volatile price of any commodity. This is due to the lag time inherent in the oil industry’s capacity to respond to changes in supply and demand. Oil fields cannot just be turned on and off at will, nor can factories quickly turn out drilling rigs and platforms.
But there is actually less mystery to oil prices than appearances initially suggest. In fact, experts are frequently able to predict price change trends. In order to assess price trends, energy market watchers are always scrutinizing economic data in various markets to understand future demand trends. Demand for energy traditionally dovetails with economic growth trends. Analysts also regularly monitor the state of various oil storage facilities around the globe. If the storage is being drawn down over time, chances are strong that the oil price will go up, and vice-versa. Oil experts scour data on rig counts and financing for equipment and exploration licenses. As such, most volatile changes in the global oil price are not as unprecedented as they appear to be.
Dramatic headlines notwithstanding, global oil prices are not at an historic low, nor are they likely to reach one. It is important to understand that oil price cycles are quite routine. Throughout the past century of commercial trade, there have been instances in which the price of oil has swung from high to low and then back up again. Therefore, while low prices will likely continue through much of 2015, we can be assured that they will eventually follow the normal cycle and rise—though not necessarily back to the historical highs of the last three years. Moreover, despite all the hype about the overconsumption of oil, its relative share in our total energy consumption has been on the decline for the last 40 years. Other sources of energy, including natural gas, coal, and oil, will likely make up equal shares of global energy consumption by 2030.
Geopolitics also affects—and is affected by—the price of oil. However, it is important to remember that geopolitical events only have long-term effects on the global oil price if they affect the physical supply or demand for oil, or if they interfere with important oil transit routes. Unless it affects production at an oil field or port, even an upsurge in Middle Eastern conflict is unlikely to cause more than a few days of market jitters, and will have little impact on the oil price over time. The impact of geopolitical events on the oil price, even those that affect the physical supply of oil, also depends on the overall state of the oil market: when supply and demand numbers are close (referred to as a “tight oil market”), even geopolitical events that cause only small reductions in oil supply will cause prices to spike. When the market is liquid, however, geopolitical events have little to no impact on the oil price. During the 2008 war between Russia and Georgia, for example, the Baku-Tbilisi-Ceyhan pipeline was attacked, disabling it for a month and causing a million barrels a day of oil to go offline. There was no observable impact on the global oil price, however, which had already begun to decline with the advent of the 2008 global financial crisis. The notion that oil prices are always entangled with geopolitical events is therefore inaccurate.
Another misconception about how geopolitical factors influence the oil price is the belief that Saudi Arabia’s refusal to cut back on its oil production, which contributed to the decrease in oil price earlier this year, is an attempt to undermine other producers that face higher production costs (like the United States) or to smash geopolitical foes that have lower currency reserves (like Iran). In reality, Riyadh’s decision was not about geopolitics at all; it was simply about its understanding of the oil market. In the new structure of the global market, the Organization of Petroleum Exporting Countries (OPEC) can only attempt to thwart the current downward trend by making incredibly deep production cuts of its own, which would benefit non-OPEC producers and allow them to continue producing at their normal volumes.
This is because, in recent years, a dramatic shift has occurred in the geopolitics of oil with the rise in importance of non-OPEC producers. This shift has been quite evident in the recent oil price decline. At the beginning of the recent price drop, many assumed that OPEC would cut back production in order to prop up the oil price. However, OPEC no longer has the same capacity to influence the oil market as it did in the past. In the 1970s, OPEC produced 60 percent of the global oil supply; because of the rise of non-OPEC producers, it was down to 40 percent by 2000. Even in its heyday during the 1973-74 Arab oil embargo that sent global oil prices skyrocketing, OPEC ended up hurting itself more than its consumers after the oil price settled to a very low price in the mid-80s. Today, OPEC cannot take meaningful action without getting non-OPEC producers on board, and its diminishing power has contributed to the current declining oil price in the short term.
While many foreign policy specialists assume that oil exporters possess a lot of power in the international political system, in reality in the current state of the global oil market, the ability to use the trade of oil as a weapon is actually in the hands of the consumers, not the producers. Major oil producers highly depend on oil revenue and are clearly vulnerable when their oil revenue slides. Consumers can deny oil producers market access and investment in their oil sectors. This is the reason that U.S. and global sanctions on oil producers—including on Iran, Iraq, Libya and Sudan—always target this sector. In contrast, oil producers cannot keep oil off the market without damaging themselves more significantly by doing so. Another producer will simply step in and supply the oil, making denial of supplies to a country almost impossible. While policymakers often focus on the security of their countries’ oil supply, the real policy challenge comes with natural gas supply. Due to its heavy reliance on permanent infrastructure such as pipelines and long-term contracts between producers and consumers, natural gas provides much more opportunity for the political use of a “gas weapon” than oil provides for an “oil weapon.”
At the same time, U.S. policy makers seem to overestimate the potential impact of the drop in global oil prices on the foreign policy behavior of major oil producers like Russia and Iran. Most producers prepare for oil price cycles and keep huge currency reserves that allow them to maintain their budgets during dry periods. In addition, there is no proven link between economic downturns and moderate foreign policy behavior. In fact, downturns sometimes motivate more extreme foreign policy reactions.
Looking forward, which geopolitical developments on the immediate horizon will affect the price of oil? First, there is a strong chance that Iran, fresh from a principle agreement on its nuclear program with the P5+1, will return at least partially to the global oil market, which would put additional downward pressure on oil prices. It will most likely take at least two years for Iran to return to its pre-sanctions production levels, but the relaxation of U.S.-Iran relations is already leading to the seepage of more Iranian oil onto the global market, as consumers are less afraid of violating sanctions. Next, in order to prop up oil prices and combat its current enemies, Tehran may be planning an attack in Saudi Arabia. Such an attack would not be carried out by Iran but by its surrogates in Yemen, who are currently fighting Saudi forces in the Yemeni civil war, and would be done in a way that is not attributable to Tehran. Any terrorist attack in Saudi Arabia, especially one on a facility connected to oil production or supply, would put significant upward pressure on the price of oil. Escalation of the conflict in Yemen could also add to a rise in oil prices—not because Yemen is a significant producer of oil (it only exports an average of 100,000 barrels a day) but because it borders Saudi Arabia and the Gulf of Aden, an important waterway between the oil producers in the Gulf and European markets. Finally, any escalation of instability in Iraq or Libya that inhibits the production or export of oil could also push the oil price upward.
Another development to watch is a potential U.S. policy decision to end the export ban on crude oil. As part of Washington’s policy response to the 1973 Arab OPEC oil embargo, the U.S. Congress enacted the Energy Policy and Conservation Act of 1975, which essentially barred the export of crude oil from the United States. Recent months have seen strong political momentum to end the ban in light of the dramatic changes that have taken place in the global oil market since the mid-1970s, especially for the United States, which is now the world’s top producer of oil. If the ban is rescinded, this will put downward pressure on the global oil price. In addition, ending the ban will lead to the re-convergence of the two main indicators of the global oil price—the West Texas Intermediate based in the United States and the Brent Crude indicator based in London.
Oil interests will also affect Russia’s next moves with respect to Iran and its nuclear deal. Russia has a strong interest in preventing the return of Iranian oil to the market, which would bring down oil prices even further. Thus, Moscow will likely take steps that could delay further implementation of the deal. Given this, it is unsurprising that Russia recently announced the cancellation of its ban on supplying a S-300 air defense system to Iran. While Russia will most likely not follow through on supplying the S-300, the threat of its delivery further complicates current negotiations on the nuclear deal.
In the next few weeks, there are specific economic and geopolitical factors that deserve special attention in anticipating the direction of the global oil price. On the economic front, continued Chinese economic slowdown will clearly keep downward pressure on the oil price, while the opposite trend will push it upward. Moreover, the trend in the value of dollar will affect the oil price. Since oil is traded in dollars, movements in the value of the dollar have a strong influence on the price of oil. Any upward pressure on the oil price will be modified by the state of near full capacity of U.S. oil storage:, the oil market has a big cushion to work through before an increase in oil demand is reflected in its global price.
On the geopolitical side, a number of factors will weigh in the oil price in the coming weeks. On June 5th, OPEC will convene for its biannual meeting. In the days prior to the conference, the oil price will be especially volatile, as analysts respond to different rumors on the anticipated behavior of the organization. A deal between OPEC and non-OPEC producers to conduct a price cut would be a major development in the global oil market, though it is not likely. In addition, the pace by which Iranian-produced oil returns to the market will be determined by which sanctions are removed following the deal on Iran’s nuclear program. If sanctions on the purchase of oil and petroleum products, insurance on the Iranian oil sector and the sanctions on the Iranian banking sector are lifted, Iranian oil exports will increase and thus there will be downward pressure on the oil price. Lastly, the geopolitical epicenter of impact on the oil price will be Saudi Arabia and Yemen. An attack that even partially affects Saudi Arabia’s capability to produce or export oil would have a dramatic upward affect on the oil price.
Thus, while various economic trends and geopolitical factors will inevitably impact the global oil market, changes in oil prices should be seen as not as unprecedented or unpredictable but as the result of basic economics, driven only by the two mechanisms of supply and demand. However, to understand the factors that affect supply and demand, a detailed understanding of geopolitics and the far-flung producers of oil around the globe is necessary. Integration of energy economics into the study of international relations will also deepen our understanding of the energy market’s behavior and its mutual influence with politics. Demystifying the oil price would also enhance and widen policy options related to oil.