Oil. It’s a commodity with a status is akin to religion. Wars have been started to control it, those in charge of it globally are almost untouchable and, regardless of the harm it does, economies still continue to worship at its sticky brown alter.
No other commodity has the hold oil does over global or household economics. When it’s price spirals, there’s civil unrest and squeezed budgets all round, but why is it so important and why is the falling price causing so many economists concern right now?
Firstly, a quick lesson on commodities markets. Commodities are things like oil, metals and wheat, the things we use to make other things, the raw product. If the prices of these commodities rise, for example, because of a fall in supply, so does the cost of the end product, ultimately squeezing household budgets, increasing inflation etc. As economies grow, demand for commodities will grow and so will prices, and vice versa. So for many economists and governments, the state of the commodities markets is a pretty good indicator to the health, or not, of economies generally.
This is all fairly simple in the case of a commodity like wheat. It’s used in food manufacture so a price rise or supply shortage really only impacts this area of manufacturing, but oil, being used in a multitude of industries, is a more complex matter.
We mainly think of oil in terms of petrol pumps and the impact on household budgets of getting to and from work, but in truth, oil has a much deeper impact on our lives. Aside from being an industry in it’s own right, all industries need energy for offices, production, transport etc. So any shortage in supply not only impacts household budgets directly in terms of petrol costs for example, but also indirectly through the increased costs of producing and transporting goods which increases the cost of the end product.
But the added complexity to the oil market is OPEC, the Organisation of the Petroleum Exporting Countries. Originally consisting of Iran, Iraq, Kuwait, Saudi Arabia and Venezuela, since its foundation in 1960, they’ve also been joined by Qatar, Libya, the UAE, Algeria, Nigeria, Ecuador, Angola and Indonesia, whose membership is currently suspended. It is considered by many to be a cartel, although some would dispute this given that its members only really control about 30% of global oil supply, not enough to fully control the market, but still enough to upset supply and price when they choose.
The main idea behind OPEC is that even in times of economic downturn they can keep oil prices fairly stable by reducing supply to reflect demand, thus ensuring there is never a glut of supply and therefore stable profits for its members. So why, with all it’s power, have we seen oil prices tumbling by about 40% a barrel since June from to $115 to $70? If OPEC can reduce supply to keep prices and profits higher, why aren’t they?
The shale industry
There are a couple of explanations. Firstly, there’s the sudden shale production boom. This is causing the members of OPEC something of a headache. Shale represents an invigorated supply to the oil and gas markets. Anyone who has followed the fracking stories in the UK will be aware there’s potential for the UK to become a major player but also China and many others are thought to have large reserves as well, and the more players in the market, the less powerful OPEC becomes.
Not only this, but the US shale market is thriving, and a cursory look at the OPEC members will tell you, it’s not exactly littered with pro-American countries.
While shale may have been worth the investment in times of high oil prices, American investors who borrowed heavily against expected high returns in shale are now struggling to make profits at the current low prices, effectively driving shale production into the ground. By keeping the cost of oil down and producing excess supplies, OPEC are essentially hoping to eventually halt the shale industry that they see as a threat to them.
Also, historically, cutting oil production to boost price has generally led to an increase in suppliers hoping to profit from the increased price, bad news for an organisation hoping to prevent newcomers to the market.
But there’s another reason, Russia. Never one to make friends generally, Russia, alongside Iran, has more than a few enemies of its own on the OPEC membership list, but in particular Saudi Arabia who has some of the lowest production costs at $5-6 per barrel, half the average of $10.20. Saudi Arabia is more than able to weather the storm of low oil prices, but Russian and Iran who are the third and sixth largest oil producers respectively, rely on high oil prices and profits to pay for their foreign and social policies, such as the sanctions placed on Russia for their activities in the Ukraine and Iranian support of the Assad regime. And current low is hurting these two particularly badly. In fact, Russia has just announced an increase in it’s interest rates from 10.5% to 17% citing the reason as being the need to protect the Rouble against falling oil prices.
While the price of oil as a commodity is an indicator of economic health, the fact that it is used in geopolitical oneupmanship with so little regard for global economics, can’t be healthy for consumers and is a prime indicator of why many economists believe cartels such as OPEC should not be allowed to continue.