What’s behind the drop in oil prices?

The past several months have seen a dramatic drop in oil prices across the globe. In July, a barrel of crude oil, specifically the West Texas Intermediate variety, sold for almost $108. Now prices are hovering around $82 a barrel. In The Atlantic, Derek Thompson wonders if we aren’t heading toward a $65 barrel. What exactly is going on with oil prices?

The simple, and uninformative answer, is changes in supply and demand. The relative importance of each factor, however, is up for debate—with important implications for economic growth and perhaps also for economic inequality here in the United States.

Let’s start with the supply side of the debate. Both Ben Casselman at FiveThirtyEight and Steven Mufson at The Washington Post peg increases in supply as the main culprit. Both writers bring up the large increase in oil production from the United States due to the fracking revolution. The technological advance has dramatically increased the supply of oil coming from the United States. In fact, Casselman has a chart showing U.S. oil production outpacing that of Saudi Arabia since late 2012. Mufson also mentions that oil companies have dramatically increased investment recently, resulting in increased supply.

But of course, the oil market isn’t perfectly competitive. The market is dominated by an oligopoly of oil-producing nations known as the Organization of the Petroleum Exporting Nations. These countries, including Saudi Arabia, Nigeria, and Venezuela decide on how much oil to produce and have a significant effect on global oil prices. So the question is why OPEC hasn’t reduced production to increase prices?

The answer is that Saudia Arabia, the “swing producer” who often sets OPEC policy, has decided not to reduce production. In fact, Izabella Kaminska argues at FT Alphaville that Saudi Arabia has an incentive to actually increase production. This increase in supply would further reduce prices and drive out other competitors, leaving Saudi Arabia as a monopolist. In other words, Saudi Arabia could be trying to drink other oil producers’ milkshakes.

Then there’s the demand side of the debate. Dean Baker, co-director of the Center for Economic and Policy Research, argues that supply actually isn’t an issue at all. Baker points out that oil production is still below projected levels made before the Great Recession. The culprit in this case is then demand. The decline in global economic growth has reduced demand and therefore oil prices.

If oil prices are dropping because the global economy is in trouble then oil producers and consumers may be in for a rough patch ahead. As Ben Walsh at the Huffington Post says, the bad news is that “oil is falling just like the stock market.” But he does have good news: the decline in oil prices is an economic stimulus because it increases disposable income for most Americans. So the price drop would help boost economic demand and economic growth while pushing economic inequality down a bit.

In the short-run, then, the global economic slowdown is helping the bottom line of many Americans. But these gains flow from the threat of another global economic recession. Silver linings amid gathering dark clouds.

October 29, 2014

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