Why is oil suddenly so cheap?

Between 1998 and 2008 the price of oil increased ten-fold. Everyone was talking about peak oil – the idea that production would plateau and demand for oil would outstrip supply. Skyrocketing prices would force us to replace what we put in our cars. In 2008 prices broke the $100/barrel ceiling – and then kept climbing.

What does it mean to say oil is $100 per barrel? When we talk about dollars we mean American dollars. Barrels are just a standard measure of volume (159 litres). The price of oil refers to a benchmark – a reference price. In the United States this is West Texas Intermediate (WTI), which is a blend of crude oils from diverse suppliers, which mingle at a physical hub in Cushing, Oklahoma. In Europe the benchmark is called Brent – a blend of North Sea produced crude oils. For a crude to become a benchmark there must be enough suppliers and enough barrels that the supply, and therefore the price, cannot be controlled by one player.

Crude oil needs to be processed and refined to produce the more valuable products, such as gasoline or jet fuel, that industry and consumers can actually use. So it is refineries that buy crude oil from producers. However refiners don’t all buy WTI. There are many different varieties of crude oil. An oil producer will mark up or mark down their crude oil relative to a reference price. This is why we call WTI and Brent benchmarks.

What determines this mark up or mark down? The quality of your oil. Oil can be light or heavy – a lighter, less viscous crude produces more of the more valuable petroleum products such as gasoline during the refining process. Oils are also classified as sweet or sour, which refers to the sulphur content. Sulphur is a pollutant which must be removed during refining. This is expensive to do. So the more sour your oil the more pricey the sulphur-removal process.

Oil producers are in the game to turn a profit.The WTI price affects your profitability as a producer.  For example, let’s say WTI is $100/barrel. If it costs you $70/barrel to extract crude oil from a well and you are selling it at a $20 discount to WTI then your profit per barrel is $10/barrel. (That’s a huge win.)

However, if the international price of oil – the WTI benchmark – falls $10 then you lose your profit margin.

A few years after WTI hit $100/barrel (and then went higher) it suddenly fell to $50. Multiply that by the millions of barrels being bought and sold and you can imagine there were some pretty big winners and losers. That’s the situation we have today. But why?

In less than one hundred and fifty words:

1. Since 2008 Europe underwent a recession which dampened demand for oil as economic growth dwindled and consumer spending dropped.

2. The United States is the world’s biggest oil consumer and used to drive global demand. However, over the past few years an energy revolution no one predicted took place in the US. As shale gas “frackers” began producing natural gas and pumping it into the regional pipeline networks, associated shale oil was also being produced. The best fields are called “wet” since they produce oil as well as gas, oil being more valuable. So within a few years the US went from being a huge importer to near self-sufficiency in crude oil production.

3. This meant that global oil markets were dramatically over-supplied. The supply glut happened because two of the biggest markets – Europe and the US – simply weren’t as hungry for crude oil anymore.

These days we actually talk about peak demand for oil. Technology and extraction processes get better every year, so it’s likely we will be able to produce oil for many years to come. However, production will become more expensive and, as environmental pressures weigh in, oil will become pricey enough that consumers and governments look for replacements. Even if that means buying an electric car or investing heavily in public transport.

Peak demand didn’t happen when prices skyrocketed in 2008. It might yet. Or it’s possible that demand for oil is dropping away. The international price will wane if other energy sources or energy efficiency measures become more competitive and attractive. We will have to wait and see if oil demand recovers in Europe or if Asia’s growth fills the gap.

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