The world price of crude oil, which has been around 100 dollars a barrel for the past 6 years, has suddenly collapsed and is now tending below 50 dollars. Many are trying to understand this rapid decrease and have proposed various explanations.

Of course, the ready explanation is simply in terms of supply and demand; but this just begs the question. The supply of oil has increased sharply in recent months—mainly because of the prolific production of shale oil in the United States, thanks to the technologies of fracking and horizontal drilling. In fact, the US is now the world’s largest producer of crude oil and US imports of oil have dropped to the lowest level in 10 years.

At the same time, the demand for oil has not increased greatly—because of depressed economic conditions and more efficient use in cars and trucks throughout the world. US imports peaked 10 years ago at 10 mbd [million barrels per day], about 50% of then-consumption, and have been dropping rapidly; Chinese imports have been rising steadily and now exceed 5 mbd.

Saudi objectives

One of the questions raised is why did Saudi Arabia, considered to be the linchpin of the OPEC cartel (or former OPEC cartel), permit the price to collapse. As I will explain, it is not in their best economic interests, from a strictly profit-maximizing point of view. Obviously, there are political considerations involved, which override simple economics.

The general view is that Saudi Arabia is permitting the price to collapse in order to put their main competitors out of business. They are doing this by not cutting their production, willing to reduce profits in the short term. Russia is one of their competitors, and a major supporter of the Alawite Syrian regime, anathema to orthodox Sunni Saudis. Russia, buffeted by sanctions imposed by the United States and Europe over her adventures in the Ukraine, is currently in bad economic shape and highly dependent on oil revenues and also on investments in oil exploration from outside companies. The same is true of Iran, a more immediate threat to Saudi Arabia. Shi’ite Iran also supports the Syrian regime and is feared to stir up anti-Saudi sentiment among the Shi’ites of the eastern Saudi oil-producing region. Allowing the price of oil to collapse fulfills certain political objectives for Saudi Arabia, which may improve its security.

Then there is the United States and Canada. Shale oil and tar sands are expensive to produce and cannot yield much of a profit if the price drops below $50. So letting the world price drop below $50 is yet another way of eliminating more Saudi competition.

Of course, at any time they wish, the Saudis can cut their production and thereby raise the world price—after they have ruined their competitors. And once competition is eliminated, it can take years before production can be revved up again.

One of the interesting issues is how to protect US producers from this kind of price manipulation. This problem has been faced before, in the 1980s, when much of the US production came from high-cost ‘stripper wells,’ (producing less than 10 barrels per day). Once the price falls below certain levels, such wells become uneconomical and have to be shut down—cemented shut, never to be re-opened.

To guard against this possibility, one needs to institute a variable import fee (VIF). The original proposal came from then-Senator David Boren, a Democrat from Oklahoma. The idea is: if the price drops below an agreed-upon level, the government will apply an import fee to produce what amounts to a floor price for imported oil. Note that this is not a tariff—although when applied it acts like a tariff, but only until the price goes up again—above the agreed-upon level. So this is simply a way to protect domestic oil production against foreign price manipulation.

Oil price model

The Saudis claim that their policy in not cutting production is to “maintain market shares.” But there may be another, unpublicized reason for Saudi actions that let the price of oil drop below an “optimal” level. So what is this optimal level? Intuitively, it can be seen that if Saudi Arabia cuts production to near-zero, profits also approach zero—even though profit per barrel is highest. Conversely, producing all-out means that profits for the extra barrels approach zero. The optimum production decision is somewhere in between these two extremes. The actual calculation is a quite difficult computational problem.

About 30 years ago, I published a monograph on oil prices and developed a mathematical model to calculate the optimal price levels (over time) for a monopolist like Saudi Arabia. The idea can be expressed simply by asking “what is the optimal price path (a set of yearly prices) over time that will result in the maximum discounted profit stream to the monopolist?” The price path then translates to “what are the monopolist’s optimal production decisions,” which in turn determine the world price. [see also “The Oil Price Enigma”]

In practice, the model is rather complicated. Following Prof Robert Pindyck (MIT), in addition to the price-fixing monopolist, the model includes the rest of the world’s oil producers, which are assumed to be “price-takers”—that is, they will produce all-out—whatever the world price. Compared to previous work, my model is “analytical”; it solves directly for the optimum price path. [Technically, the optimum price-path model belongs to the class of ‘optimum control theory’ models, well known in physics and theoretical economics (where it is labeled ‘Pontryagin problem’).]

[The model allows for various parameters, like time delays in production and consumption decisions, taking into account that they depend on previous prices. The model also includes both short-term and long-term price-elasticities of demand and supply, as well as the rising costs of production for both monopolist and price takers.]

Oil price collapse

My model did not consider what Yale economist Wm. Nordhaus called a “backstop technology” (defined as an unlimited energy resource that would take over when the oil price becomes too high). In the 1980s, the price of natural gas was so high and the price of oil so low that liquefied natural gas (LNG) did not really enter into consideration. Nowadays, however, natural gas is a serious competitor to crude oil. Specifically, with natural gas around 4 dollars per million BTU (British Thermal Units), the price of oil should be about $24 a barrel, strictly on the basis of BTU equivalency. [Oil is a more flexible fuel than gas, which adds a considerable premium to the oil price.] This disparity between oil prices and gas prices became apparent by 2010, as soon as the US natural-gas price fell from $13 to $2 per million BTU, thanks to the shale revolution. [See also “Oil Price Enigma”] So the real question is: what has taken so long for the price of oil to collapse?

A partial answer is the increase of oil production worldwide, especially in the US, plus oil conservation, especially for motor vehicles, and the actual substitution of LNG and CNG (compressed natural gas) for many oil applications. In addition, major oil companies actually constructed expensive conversion plants to turn natural gas into gasoline, like Shell-Qatar’s GTL (gas to liquid) Pearl plant. Such plants cannot be built overnight and are no longer really economic with today’s oil prices. Yet they may have provided the impetus for the collapse.

What of the future?

Of the many parameters that are fed into my oil-price model, the most important for determining future prices turns out to be discount rate. Note that we are not talking about the normal economic discount rate, but rather the discount rate as seen by the Saudi oil producers. It is perhaps obvious that if they fear a loss of control over their oil, they will produce all-out and accept lower prices, even though it is not profit-maximizing. We may be seeing this now in their current decision to let prices collapse—even though their fears are not spelled out explicitly; they prefer to talk about “keeping market shares.”

It’s quite difficult to predict future oil prices; politics, especially as related to environment and CO2 emissions, has become more important than rational economics. Here are some examples: approval of the Keystone XL oil pipeline; legal challenges to Obama’s “war on coal” and the more recent plan to control methane emissions (which might cripple the shale-fracking revolution). Internationally, we have many more unpredictables: terrorist attacks, sabotage, and revolutions that affect oil production in key nations; all the way to war in the Persian Gulf that might cut world oil supply severely—with a huge jump in the world price.