Reasons behind the fall in oil prices

Saudi Arabia's deep pockets and a strong financial system could help the country to ride out a low-price environment in order to protect its market share, explain Abheek Barua and Bidisha Ganguly.

The sharp decline in oil prices over the last couple of months is yet another example of how markets can take even the canniest of investors and analysts by surprise.

Just when they were fretting about political risks in Libya, Ukraine and Iraq and the possibility of an escalation in prices, they went into free fall.

The next meet of the Organisation of the Petroleum Exporting Countries or OPEC is due on the November 27 but it is unlikely to change the current dynamics of the oil market. 

A key question is: can we explain it by simple demand and supply metrics or will some other analytical approach give us a more complete picture than meets the eye?

Clearly, one cannot entirely overlook the "demand-supply" dimension, particularly the reduced demand for imports from the US. 

Thus, at the heart of the price decline is the "fracking" revolution in the US that has ramped up domestic oil production in the country to nine million barrels per day (mbpd), close to Saudi Arabia's production level of around 9.6 mbpd. 

Investments have also been made to build pipelines that connect the oil producing centres to the refineries, which are on the coast and were earlier serviced through imports. 

Added to the glut in production is the deepening of recessionary conditions in Europe, Japan and faltering growth in China. 

Yet these developments were not unexpected and one wonders why a decline of this magnitude was not foreseen. This is the point where we need to look beyond the simple calculus of demand and supply and explore more strategic and "political economy" issues. 

The one assumption made by most analysts was that the OPEC would maintain its cartel and keep prices above a certain level by cutting production. This scenario has, however, failed to materialise, with OPEC members increasing their supply to a 12-month high in September 2014. 

Even though several OPEC members are calling for a production cut to be announced at their next meeting later this month, this will not happen unless Saudi Arabia takes the lead. 

Observers of the Saudi kingdom are pointing out that they may prefer to ride out a low-price environment in order to protect their market share. 

Theories of cartels are replete with examples of such strategic behaviour, especially when an incumbent is threatened by competition from external sources. 

In this case, however, one cannot help but wonder if the political equations between the US and Saudi Arabia did not play a role. 

The loud and some "triumphal" assertions about energy independence coming from the US may have irked the Saudis. 

They are now prepared to use their cash reserves if required till their competitors, including the US, are driven out of business and they emerges as a uber powerful supply behemoth. 

According to the Global Economic Monitor prepared by the Institute of International Finance, Saudi Arabia's deep pockets, high debt ratings, cheap borrowing rates, and a strong financial system enable the country to ride out a low-price environment. 

According to some estimates, the fracking "industry" will no longer be profitable if oil remains below $80 per barrel. This has prompted some observers to expect a quick reversal of prices as new extraction projects are shelved.

However, lead times are high in the oil industry and production takes time to match expected demand. It is possible that US production will continue to rise throughout the first half of 2015 even as OPEC refuses to cut production. 

In which case, the global economy needs to be prepared for a further drop in oil prices. Russia's President Vladimir Putin has already sent out a warning about a "catastrophic" slump in oil prices. 

Of course, what may be catastrophic for Russia will not be so for others and especially for oil importers, this may indeed bring some welcome respite. 

India needs to keep its fingers crossed and pray that the fraternal spirit doesn't suddenly return to the OPEC. 

Abheek Barua is with ICRIER. Bidisha Ganguly is Principal Economist, CII.