Explore Reasons of Falling Oil Prices and Analyze the Relevant Impacts

Darson Chiu

        The prices of crude oil have been dropping significantly, which obvious caught great attention around the world. The reasons behind could be complicated, whereas the potential impacts might be complex as well.

        In terms of West Texas Intermediate (WTI), the oil price per barrel was US$ 106.07 on average in June 2014. However, it was priced at US$ 49.56 approximately in February 2015 indicating a 53% of price plummet during 8 months. Such oil price tumble is definitely not unprecedented. An obvious example not too long ago when the WTI dropped from US$ 133.93 in June 2008 all the way down to US$ 39.16 on average per barrel in February 2009, the ratio of crude plunge was a high as 70%. The previous major oil price fall was simply caused by the most recent global financial crisis, and nobody has been trying to debate that. After all, the underlying principle was self-explanatory. On the contrary, the ongoing pricing dip was triggered by multiple reasons, and the world is still paying great attention to its development. In economics theory, the price is decided by demand and supply. To apprehend the trend of crude prices, we thus need to analyze the propositions of both demand and supply sides. Furthermore, as all commodities are priced at the US dollar meaning the fluctuation of greenback also has its significant role in determining the prices of crude oil.

      Of course, weaker world demand is one of the main reasons contributing to the tremendous fall of crude oil prices. By reviewing economic performances of global major economies from the first quarter of 2014 up to dates, we can conclude that the US has been the only economy enjoying a solid recovery despite of an enduring west coast strike paralyzing 29 ports. Back to the story of weaker demand, mainland China has to be put under the spotlight. China's economic growth target for 2014 was set in March last year as 7.5%; it turned out that the actual growth rate was 0.1 percentage point short to meet the mark. In addition to the failure of fulfilling its annual goal, a 7.4% GDP growth rate signaled a new low for the second largest economy in the world for since 24 years ago. Structural reform conducted by Beijing is hurting China's internal demand growth, whereas its external growth has no choice but relying on input substitution policy.

        Besides China's role, the supporting roles of weaker demand should be casted by Europe and Japan. Both Europe and Japan have long lasting debt issues to deal with; imposing expansionary fiscal stimulus package is out of their options. Both of them are still fighting deflation with extremely slack monetary measures. The Bank of Japan (BOJ) introduced its Quantitative and Qualitative Monetary Easing (QQE) in April 2013 and aimed at overcoming years of deflation and anchoring 2% inflation in just about two years from then. The European Central Bank (ECB) kicked off its European style quantitative easing (OE) in March 2015 by purchasing 60 billion euros of debt per month. The ongoing QQE by BOJ and fresh QE by ECB have stoutly suggested that growths in these two areas remained tepid, and monetary operations were the obliged means due to fiscal crash. Ironically, the collapse of crude oil prices has further clouted their efforts to cope with deflation.

        In addition to the episodes of weak demand, over-supply also played a critical role as the main culprit in driving down the crude oil prices. The introduction of shale oil fracking technology widely recognized as an oil production revolution certainly helped shift out the supply curve. Such technological advance has dramatically increased the supply of oil coming from the US. Nevertheless, the global oil prices are not simply decided by supply and demand equations, and the oil market is not in the slightest perfect competition. First, the oil prices are actually determined in the market of oil futures mostly by speculators and to some extent by hedgers. Second, the global oil market is oligopoly, a well known example of econ 101 textbook. Furthermore, this oligopolistic market is dominated by countries with large share of oil reserves but productions. With around 80% of world crude oil reserves, nations of the Organization of the Petroleum Exporting Countries (OPEC) have the say about the quantity to produce and the significant influence on global crude oil prices.

      Saudi Arabia, the leader of OPEC, laid down its subterfuge to drive out competitors by not reducing oil production and thus keeping oil prices low. Phase one would be to push away Russia, 14% share of world oil production. With the continuous economic sanctions by the West on Russia for its invasion in Crimea, plummeting oil prices are further hurting the Russian economy. Phase two would be the plot to shut down shale oil producers in the US. Most of the shale oil producers in the US are small and medium sized companies, and the cost of production on average stands at US$ 50-75 per barrel. As for OPEC members especially Saudi Arabia, their crude oil production is a typical scale economy mode; therefore the production cost per barrel can be as low as US$ 20. With the cost advantage, OPEC has been striving for taking back market dominance from the US Shale oil producers. With collapsing crude prices, the U.S. shale oil industry responded by slowing its blazing growth and holding back expansion plans.

        In addition to the weaker global demand and ample oil supply, stronger US dollar is also pressing down crude prices. The US Federal Reserve launched three rounds of quantitative easing measures since 2008. The US QE generated a huge amount of hot money flowing to emerging economies as well as markets of commodity. The last round of QE ended in October 2014, and the hot money began to retreat and flew back to the States. Besides the moratorium of QE, a potential hike in interest rate to further tighten the monetary policy has been rumored since the second half of 2014. The Federal Funds rate has been set at a range of 0-0.25% since December 16, 2018. A future rate hike will certain strengthen the greenback. As crude prices are denominated by the US dollar, a stronger dollar makes crude cheaper for sure.

        Crude price collapse takes serious toll on oil producers; nonetheless, it is categorically advantageous for Taiwan's economy. Regardless of the fact that the production and trading of certain petrochemical industries were negatively impacted by the low oil prices, the cost-down effect has helped promote overall industrial production and consumption in Taiwan to a certain extent. What ought to be placed a great emphasis on would be the trend of future crude prices. According to the forecast conducted by US Energy Information Administration in March 2015, crude prices will gradually go back up to US$ 60-70 per barrel. That means the Taiwan's economy may be losing the luxury of cost down effect. Nevertheless, that could also imply a rebound in demand above and beyond the stories of supply side and dollar trend. That might not inevitably be a bad news in spite of everything.

(Dr. Darson Chiu is the Director General of CTPECC and Deputy Director of Macroeconomic Forecasting Center, Taiwan Institute of Economic Research.)