Economics Assignment

The low oil prices we currently see are a result of a confluence of many factors. We will focus on three major ones, one that is long-term, and two that are short-term. Whereas in the past Saudi Arabia reined in higher oil prices by increasing production, their declination to do so (and a large increase in demand from emerging economies, particularly China), resulted in an ever-climbing oil price.  The price of oil broke through the $100/barrel barrier at the beginning of 2008, spiking later in the year at just past $147/barrel.

Such high prices resulted in many once economically-infeasible sources of oil (such as Canadian Tar Sands and American Shale Oil) now being invested in and brought online.  Likewise, many once economically infeasible energy substitutes for oil were now viable (renewable energy sources, ethanol fuel from corn and sugarcane).

One of the short-term causes of the current bottoming out of oil prices started in the summer of 2014 as unexpectedly weakened demand from China and Europe, coupled with America getting more and more of its oil from domestic supplies, resulted in a surprise glut of oil on the world market.

Finally, when Saudi Arabia refused to cut their own oil production to boost oil prices, the price of oil tumbled to just below $46/barrel at the end of January.

With Saudi Arabia’s marginal costs to produce a barrel of oil to be around $5/$6, they can afford to have such a low oil price (price of government programs not withstanding).  Meanwhile, industry rivals such as American shale oil and other high margin costs per barrel producers, and geopolitical rivals such as Russia and Iran, cannot long afford to keep producing oil at such a low price.  This, coupled with the heavy investment and low-production time it takes in producing oil can force many rivals and substitutes out of business if Saudi Arabia allows the price to stay so low for too long.  Once such rivals have been chased from the market Saudi Arabia can cut their own production resulting in higher prices without losing market share.