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The Oil Price Crash of 2014

December 19, 2014

Oil storm clouds image via shutterstock. Reproduced with permission.

Oil storm clouds image via shutterstock. Reproduced with permission.

Oil prices have fallen by half since late June. This is a significant development for the oil industry and for the global economy, though no one knows exactly how either the industry or the economy will respond in the long run. Since it’s almost the end of the year, perhaps this is a good time to stop and ask: (1) Why is this happening? (2) Who wins and who loses over the short term?, and (3) What will be the impacts on oil production in 2015?

1. Why is this happening?

Euan Mearns does a good job of explaining the oil price crash here. Briefly, demand for oil is softening (notably in China, Japan, and Europe) because economic growth is faltering. Meanwhile, the US is importing less petroleum because domestic supplies are increasing—almost entirely due to the frantic pace of drilling in “tight” oil fields in North Dakota and Texas, using hydrofracturing and horizontal drilling technologies—while demand has leveled off.

Usually when there is a mismatch between supply and demand in the global crude market, it is up to Saudi Arabia—the world’s top exporter—to ramp production up or down in order to stabilize prices. But this time the Saudis have refused to cut back on production and have instead unilaterally cut prices to customers in Asia, evidently because the Arabian royals want prices low. There is speculation that the Saudis wish to punish Russia and Iran for their involvement in Syria and Iraq. Low prices have the added benefit (to Riyadh) of shaking at least some high-cost tight oil, deepwater, and tar sands producers in North America out of the market, thus enhancing Saudi market share.

The media frame this situation as an oil “glut,” but it’s important to recall the bigger picture: world production of conventional oil (excluding natural gas liquids, tar sands, deepwater, and tight oil) stopped growing in 2005, and has actually declined a bit since then. Nearly all supply growth has come from more costly (and more environmentally ruinous) resources such as tight oil and tar sands. Consequently, oil prices have been very high during this period (with the exception of the deepest, darkest months of the Great Recession). Even at their current depressed level of $55 to $60, petroleum prices are still above the International Energy Agency’s high-price scenario for this period contained in forecasts issued a decade ago.

Part of the reason has to do with the fact that costs of exploration and production within the industry have risen dramatically (early this year Steve Kopits of the energy market analytic firm Douglas-Westwood estimated that costs were rising at nearly 11 percent annually).

In short, during this past decade the oil industry has entered a new regime of steeper production costs, slower supply growth, declining resource quality, and higher prices. That all-important context is largely absent from most news stories about the price plunge, but without it recent events are unintelligible. If the current oil market can be characterized as being in a state of  “glut,” that simply means that at this moment, and at this price, there are more willing sellers than buyers; it shouldn’t be taken as a fundamental or long-term indication of resource abundance.

2. Who wins and loses, short-term?

Gail Tverberg does a great job of teasing apart the likely consequences of the oil price slump here. For the US, there will be some tangible benefits from falling gasoline prices: motorists now have more money in their pockets to spend on Christmas gifts. However, there are also perils to the price plunge, and the longer prices remain low, the higher the risk. For the past five years, tight oil and shale gas have been significant drivers of growth in the American economy, adding $300 to 400 billion annually to GDP. States with active shale plays have seen a significant increase of jobs while the rest of the nation has merely sputtered along.

The shale boom seems to have resulted from a combination of high petroleum prices and easy financing: with the Fed keeping interest rates near zero, scores of small oil and gas companies were able to take on enormous amounts of debt so as to pay for the purchase of drilling leases, the rental of rigs, and the expensive process of fracking. This was a tenuous business even in good times, with many companies subsisting on re-sale of leases and creative financing, while failing to show a clear profit on sales of product. Now, if prices remain low, most of these companies will cut back on drilling and some will disappear altogether.

The price rout is hitting Russia quicker and harder than perhaps any other nation. That country is (in most months) the world’s biggest producer, and oil and gas provide its main sources of income. As a result of the price crash and US-imposed economic sanctions, the ruble has cratered. Over the short term, Russia’s oil and gas companies are somewhat cushioned from impact: they earn high-value US dollars from sales of their products while paying their expenses in rubles that have lost roughly half their value (compared to the dollar) in the past five months. But for the average Russian and for the national government, these are tough times.

There is at least a possibility that the oil price crash has important geopolitical significance. The US and Russia are engaged in what can only be called low-level warfare over Ukraine: Moscow resents what it sees as efforts to wrest that country from its orbit and to surround Russia with NATO bases; Washington, meanwhile, would like to alienate Europe from Russia, thereby heading off long-term economic integration across Eurasia (which, if it were to transpire, would undermine America’s “sole superpower” status; see discussion here); Washington also sees Russia’s annexation of Crimea as violating international accords. Some argue that the oil price rout resulted from Washington talking Saudi Arabia into flooding the market so as to hammer Russia’s economy, thereby neutralizing Moscow’s resistance to NATO encirclement (albeit at the price of short-term losses for the US tight oil industry). Russia has recently cemented closer energy and economic ties with China, perhaps partly in response; in view of this latter development, the Saudis’ decision to sell oil to China at a discount could be explained as yet another attempt by Washington (via its OPEC proxy) to avert Eurasian economic integration.

Other oil exporting nations with a high-price break-even point—notably Venezuela and Iran, also on Washington’s enemies list—are likewise experiencing the price crash as economic catastrophe. But the pain is widely spread: Nigeria has had to redraw its government budget for next year, and North Sea oil production is nearing a point of collapse.

Events are unfolding very quickly, and economic and geopolitical pressures are building. Historically, circumstances like these have sometimes led to major open conflicts, though all-out war between the US and Russia remains unthinkable due to the nuclear deterrents that both nations possess.

If there are indeed elements of US-led geopolitical intrigue at work here (and admittedly this is largely speculation), they carry a serious risk of economic blowback: the oil price plunge appears to be bursting the bubble in high-yield, energy-related junk bonds that, along with rising oil production, helped fuel the American economic “recovery,” and it could result not just in layoffs throughout the energy industry but a contagion of fear in the banking sector. Thus the ultimate consequences of the price crash could include a global financial panic (John Michael Greer makes that case persuasively and, as always, quite entertainingly), though it is too soon to consider this as anything more than a possibility.

3. What will be the impacts for oil production?

There’s actually some good news for the oil industry in all of this: costs of production will almost certainly decline during the next few months. Companies will cut expenses wherever they can (watch out, middle-level managers!). As drilling rigs are idled, rental costs for rigs will fall. Since the price of oil is an ingredient in the price of just about everything else, cheaper oil will reduce the costs of logistics and oil transport by rail and tanker. Producers will defer investments. Companies will focus only on the most productive, lowest-cost drilling locations, and this will again lower averaged industry costs. In short order, the industry will be advertising itself to investors as newly lean and mean. But the main underlying reason production costs were rising during the past decade—declining resource quality as older conventional oil reservoirs dry up—hasn’t gone away. And those most productive, lowest-cost drilling locations (also known as “sweet spots”) are limited in size and number.

The industry is putting on a brave face, and for good reason. Companies in the shale patch need to look profitable in order to keep the value of their bonds from evaporating. Major oil companies largely stayed clear of involvement in the tight oil boom; nevertheless, low prices will force them to cut back on upstream investment as well. Drilling will not cease; it will merely contract (the number of new US oil and gas well permits issued in November fell by 40 percent from the previous month). Many companies have no choice but to continue pursuing projects to which they are already financially committed, so we won’t see substantial production declines for several months. Production from Canada’s tar sands will probably continue at its current pace, but will not expand since new projects will require an oil price at or higher than the current level in order to break even.

As analysis by David Hughes of Post Carbon Institute shows, even without the price crash production in the Bakken and Eagle Ford plays would have been expected to peak and begin a sharp decline within the next two or three years. The price crash can only hasten that inevitable inflection point.

How much and how fast will world oil production fall? Euan Mearns offers three scenarios; in the most likely of these (in his opinion) world production capacity will contract by about two million barrels per day over the next two years as a result of the price collapse.

We may be witnessing one of history’s little ironies: the historic commencement of an inevitable, overall, persistent decline of world liquid fuels production may be ushered in not by skyrocketing oil prices such as we saw in the 1970s or in 2008, but by a price crash that at least some pundits are spinning as the death of “peak oil.” Meanwhile, the economic and geopolitical perils of the unfolding oil price rout make expectations of business-as-usual for 2015 ring rather hollow.

22 Comments, RSS

  • Don’t forget that Americans now see lower gasoline prices as a long term situation (Thanks, Fox News!) and are going out and buying more SUVs and all those new, high powered Muscle cars (hey, those new Corvettes are very nice). So, if the economy does pick back up, so will oil demand.

    The mid-term situation just might be – more demand but far less supply because so many un-conventional projects were defunded due to low oil prices. What does that give us? Skyrocketing prices! What does that do? Kills demand. Looks like one thing we can all count on – volatility in the global economy.

  • Yep, it’s the “goldilocks” scenario you’ve been espousing all along Richard. Once we get past peak there’s really not much room for maneouver for producers; different causes and effects each with their own temporal, geographic and political parameters. Who’d be risking their savings on what will happen next?

  • spot on EVHappy. I think it is a matter of months for the next yo-yo move.

  • Isn’t this the roller-coaster ride that some people predicted would characterise the peak of oil production? With the remaining oil supplies in the hands of the “market” instead of controlled by government as a bridge to a sustainable society, then I suppose we can expect dramatic rises and falls in price and supply right up until we drop off the resource cliff. I have never expected that there would be a steady decline without government intervention.

  • There is something I do not understand. Let’s imagine we have an excess offer of 2 mbd causing the prices fall. This represents well under 3% of global consumption. How on Earth can an excess offer so small bring prices down a 50%?

    The Arabs can cut their price as much as they want, but even if they gave their petrol for free they would still be unable to supply everybody.

    If there is indeed an excess offer (overproduction) of 2 mbd, then I would understand the price of those 2 mbd falling sharply. The bulk of global production though, should not see important price decreases. The normal thing to do then, would be for the Arabs to leave 2 mbd underground. This would surely mean a lower income for them, but still far from the income fall caused by a 50% price decrease.

    I absolutely don’t understand why, say Russia, has started selling its oil almost half price. On top of that, I would imagine that producers are supplying their oil in accordance with agreements signed many months and even years in advance, at prices set in those agreements. I would understand falls in prices only some months after the start of overproduction, and only for limited volumes of oil, more or less corresponding to the volume of overproduction. And I would expect producers to quickly adjust their production to demand, especially those richer producers possessing the least costly oil (i.e. the Arabs).

    In conclusion: I fail to understand the present situation at all.

  • “I absolutely don’t understand why, say Russia, has started selling its oil almost half price.”

    Price is determined by the market which is ruled by the law of supply & demand, so it’s not about the prices that producers want, but the prices consumers are willing to pay based on the amount of oil available in the market place. By producing more oil (or not decreasing production) SA is effectively driving the price down because supply is high and demand is low. Russia has no choice but to sell its oil at the market rate; if they asked for more money, consumers would simply buy it from somewhere else.

    ” I would imagine that producers are supplying their oil in accordance with agreements signed many months and even years in advance, at prices set in those agreements.”

    Why would you make that assumption? Agreements like the one you suggest would require centralized control of global oil markets that were managed by governments rather than economies. Even if governments control domestic production, the marketplace is global and even the most totalitarian regime must conform if it wishes to participate in the global economy.

    I think it’s important to bear in mind that oil is a commodity and is either in the ground, in transit or in use. Though there may be physical reserves here and there, oil is basically consumed as soon as it hits the market.

    Hopefully that helped. This website is a fantastic resource for understanding the energy situation.

  • It is confusing. I’ve read that prices for other commodities are also falling. This has been suggested to be a sign of global economic weakening. So perhaps the current surplus production is just a symptom of buyers not being willing to purchase, and the surplus is not, in and of itself, the cause of the price decline.

  • Thank you for your explanation, Pigeon.

    I realize that prices were not agreed much in advance, but I still do not understand how buyers can bring them down to this extent. You say they would buy their oil elsewhere otherwise. Where from?

    The excess offer is barely 2mbd, so this is how much oil buyers can decline to buy unless prices get lower (in which case it can be bought and either added to strategic reserves, and/or be sold lowering in turn a bit the retail price, which would induce a bit more consumption and therefore boost a little bit the economy).

    Buyers cannot afford to stop buying the oil they need. They cannot buy it more expensive than affordable to them, of course, but it was clearly affordable at $80, and even above $100 before that. They didn’t like those prices, which damaged their economy, but they still had to buy. It is irrational to suppose they could now refuse to pay, say, $75. If they were obliged to pay $80 just a couple of weeks ago or so, like it or not, how come they wouldn’t buy now at $75?

    To me it doesn’t make any sense. If Russia says they are not selling under $75, there is no way the rest of producers can increase their production to satisfy the demand at a lower price. The room they have to play this game is only the 2mbd excess plus whatever increase of production they could make, and this would not be enough to replace the Russian oil. And it’s not just Russia. It is virtually all the world producers save the Arabs who are badly damaged by the $60 price.

    Again, I cannot understand how the prices plunged so much, not even in the hypothesis of some machiavelic agreement between the Arab countries and the major western companies.

  • Nils, it is clear that whatever amount is left by the buyers is surplus production. The overproduction figure depends on buyers reactions to prices.

    The only explanation I can think of right now, as to how come producers are forced to lower so much their prices, is not the excess 2mbd. It is a fast degradation of the buying countries economies, making them unable to afford and/or to have no use for same volume of oil bought until then.

    Thus, oil prices would not be brought down by the acknowledged overproduction of 2mbd, relative to a supposedly stable demand level, but rather by a contracting demand. It means that continuing to produce a given amount of oil would result in increasing overproduction, because the buying countries economies and demand are in decline. Their demand level could only be kept the same by reviving a bit their economies through diminishing oil prices.

    It may be that the world is entering some terminal, collapsing stage of oil prices volatility, where prices take successive, abrupt ups and downs, with an overall tendency of demand (and maybe prices as well, or not) to go down.

    Therefore, supplying countries would counter a faltering global demand with relevant price reductions without cutting oil production, expecting demand to rebound.

  • In an eggshell, you have the right idea. The buyers (oil refiners) must buy the crude and the producers must sell what they produce…there is no real long term storage options as there are for things like gold and cash. The need to move these commodities forces sellers and buys to adjust their expectations.

    The first link in the article: http://euanmearns.com/the-2014-oil-price-crash-explained/ does a great job of explaining how a seemingly insignificant amount of surplus can greatly impact the price of oil. One of the bits I found most interesting was this:

    ” Prior to 2004, oil supply was fairly elastic to changes in price, i.e. a small rise in price led to a large rise in production. This is explained by OPEC opening and closing the taps. Post 2004, oil supply became inelastic to price, i.e. a large change in price led to marginal increase in supply. This is explained by the world pumping flat out.”

    Also, (to your question above) as I understand it an oil refiner can take whatever oil is cheapest. So for example, a refiner in Galveston could use oil that arrives via ship from any country or via pipeline (?). Their concern is going to be the overall cost of production, so they will generally go for whatever is cleanest and easiest to transport, but if, say, Russia was the only country pumping oil, then everyone would have to buy from them. Feel free to correct me if someone has a better answer, after all, I’m just a pigeon with a bird brain.


  • It is easier to understand if you grasp the concept that the system is not perfect. Much about speculation is about human emotions, computer algorithms trying to reduce their loses moment by moment, etc. Volatility goes up as certainty goes down. We have overshoot and undershoot. That is the nature of the markets.

    In a perfectly rational world where the resources of Earth were carefully managed, things would be much more comfortable for the 1 billion people on living on this planet. Notice, I wrote 1 billion, not the overpopulated 7 billion people we have today with no chance of enough resources for comfort and dignity.

  • It’s my understanding that airlines at least, being so vulnerable to fuel price rises, contract for fuel at fixed prices some months in advance. Maybe some other industries do the same.

  • The Ukraine “revolution” that led to the embargoes was, I believe, a response to the earlier initial deal with the BRICS nations (Brazil, Russia, India, China and South Africa) to create a BRICS Investment Bank to compete against The World Bank and the I.M.F. (both instruments of U.S. policy) and traded in currencies not of the petro-dollar kind – eventually Russia and China signed three historic deals, two for energy and one for currency-protection (in mutual currencies only). You can track the progress of American aggression by the level of rhetoric and policy change that follow each and every BRICS’s meeting, declaration or signed agreement.

    Control of the world’s only reserve currency, that happens to be tied to all energy trade by law, enables the U.S. dollar with more value that its intrinsic worth – its also the only reason America was able to buy it’s way out of the peaking of oil supply that caused the GFC. Defending the U.S. petro-dollar hegemon (monopoly) is as much a national security issue as defending against violent revolution – that’s really ironic considering the likely violent revolution that would follow the collapse of the dollar’s value. The current oil surplus is a disaster in the making, with ramifications that extend further than anyone has so far seen, from the short-term all the way out to the fate of the species.

    There’s a disconnect between industry and its supply (production), and the market and its daily trade in delivery (months ahead). Industries that rely on oil don’t suffer from daily swings in refined oil products such as gasolene, so the effects of any swing in price isn’t felt immediately, and stored reserves lessen the impact as well. However, industries that produce oil that is sold daily are effected immediately by swings in price – their value can diminish and returns on the old E.R.O.E.I. can force them to shut-in and shutdown production. And this is where it gets messy – starting up just about any kind of oil play after it has been shutdown is not an immediate act, and starting all of them in a timely manner, especially in the midst of a supply crunch, likely won’t happen.

  • The 2005 “Hirsch Report” from US Department of Energy made this prediction. (Increasing volatility of prices at Peak Oil.)

    I think Colin Campbell made similar predictions in the 1990s.

  • Duncan Zarathrustra

    The bumpy plateau indeed!

  • Hollywood ordered Saudi Arabia to lower it’s prices. Simple. Why? Fracking chemicals were getting into Los Angeles’ drinking water from wells in Utah and Colorado. Flowing into the Colorado River, then to Lake Mead (held back by the Hoover Dam) and then on to Hollywood, CA. If you don’t know Hollywood’s tremendous influence and Power (Hollywood rules America) then you don’t suspect all this. And, of course, Mr. Heinberg still has the wool pulled over his eyes by TV and movie propaganda, as you probably do. Face it, the clowns are running the show!

  • Spot on Strange Planet.
    This exactly what Kenneth Deffreyes predicted in his book Beyond Oil. He predicted very volatile prices going in a number of cycles, before finally sagging into collapse.
    This is the second cycle.
    How many cycles is the real trick, but those of a mathematical bent who can calculate integral proportional and derivative functions, if they can get the data, might be able to enlighten us all. Any control systems engineers here ?
    It is all there, in the figures if your maths is good enough.

  • d.mchale-tree hugger's ball

    Sorry for the late entry. It’s about the paper now. Merger and acquisition, the major players will align with the forces of finance they have constructed, gobble up the those with oil assets as we get closer to the ‘edge’ I’m thinking. These majors want to stabilize price flux because their other entities are being harmed stop capitalism imploding and feeding on it’s own selfie. Not sure you all have been watching the Bakken and Eagle Ford ‘finds’ the major players have now begun moving in. The interesting caveat is these ‘junk bonds’ used to finance other ventures outside the oil industry and their long arms. Vulture capitalism is about to run it’s favorite horse about the ‘right time'(?). I was interested to see the nuance in language used by our hero Richard-Eurasia-in the piece that reinforces the fact the mustache is but an oil smear on the poster of ‘Big Brother’. I saw this on Neil Young’s web site a few years back: “1984, Was Not Supposed to Be an Instruction Manual”. To think the NSA Report and the CIA Report on Torture are not children of this nightmare is Newspeak, they are components on the other side of the ‘edge’. Sorry to be so scary. If we ain’t pushing co-operatives we’re duping ourselves into greater Political Flag waving and “Hate Week” love affairs. Ain’t no one giving solar or wind away FREE.
    When I asked her how did she see it in the future she said; “It will be bullets and beans if we don’t git it done, Dennis.” Judy Bonds 2010

  • Isn’t this the same as every other commodity. Bankrupt small players, consolidate monopolies, hike prices and fill yer boots till it all runs out……?

  • why is it happening? simple, it is to facilitate the increase of pressure on russia, sanctions are being implemented and russia biggest export is oil, so they intend to undermine russia further by reducing the gains they make through the sale of oil.
    this current ‘crash’ in the price of oil should glaringly indicate to people that the price of oil being high was not scarcity, but purely by market manipulation.
    for the record, i neither believe the story about oil running out nor oil or carbon being detrimental to life on earth in anyway.
    i believe (with scientific studies to prove) that oil is not the fossilised extract from decaying matter but is Abiotic and produced by the earths mantle.
    the whole argument of ‘oil running out’ and ‘save the planet from fossil fuel’ was fostered by oil giant funded political ‘green’ movements inorder to inflate the price so ridiculously high in the first place.
    oil isnt running out, it will never run out, oil is the product of the earth just as water is a product of the earth and will not run out either.
    the climate bullcrap about co2 and climate change is also an oligarch funded fairy story, itself designed to create an invisible tradeable stock commodity that neither needs transportation or storage, does not need to be mined and will never run out…..the ultimate in stock market gambling chips.
    most people have heard the term ‘sheeple’
    those people who believe the earth is dying, that the sun will go out, that co is a greenhouse gas of any significance, that water is running out, that mankind is doomed due to overpopulation……you are the sheeple and you dont even know it, you are being played for fools by the oligarch pied piper, hypnotised and blinded to truth whilst carrying a belief that you are in possession of the truth, when one day your eyes open (if they ever do) all you will see in your hand is lies.

  • A report on NBC recently stated that the Saudis can afford to go even lower on the price of oil because it only costs them something like $15 to produce a barrel, and that it only costs the Russians about $25. Of course, I don’t consider NBC News a great source of information, but the cost of production is something we need to include in this discussion, as it will help decide which producers survive and which do not. But if those figures reflect reality, doesn’t it seem the Saudi action is more likely to hurt US oil production than Russian?
    I would also like to hear from someone in the know about just how long the Saudis and friends can go on forcing these huge outputs from their wells without beginning to run short, perhaps forcing them into the category of producers who must then spend a lot more to continue pumping.
    Finally, I would like to learn more about what’s happening with the tar sands in Canada. Is it possible this cheap oil will put that whole horrifying mess out of business? What will that mean for Canada – aside from perhaps getting rid of Stephen Harper? I do know that the Canadian dollar has already fallen a lot.

  • Fossil fuel-led growth was always a broken formula: ever-increasing population and consumption based on finite resources. Our ability (or misfortune) to discover more reservoirs only delays the inevitable and stifles the will to change to renewables. Very sad stuff.