West Texas Intermediate (WTI) crude oil cost US$106.07 per barrel on average in June last year. However, it reached US$49.56 in February, indicating a price plummet of 53 percent over eight months. Such tumbling oil prices are not unprecedented: When WTI crude dropped from US$133.93 in June 2008 to US$39.16 per barrel in February 2009, it lost as much as 70 percent of its value.
The previous major oil price fall was caused by the most recent global financial crisis; nobody has been trying to debate that. After all, the underlying principle was self-explanatory. On the contrary, the ongoing price dip was triggered by multiple reasons, and the world is still paying great attention to its development.
In economics theory, price is decided by demand and supply. To apprehend the trend of crude prices, observers must analyze the propositions of both the demand and supply sides.
Furthermore, all commodities are priced in US dollars — meaning the fluctuation of the greenback also has a significant role in determining crude oil prices.
Weaker world demand is a major reason behind the tremendous fall of crude oil prices. A review of the economic performance of global major economies from the first quarter of last year until now shows that the US has been the only economy enjoying a solid recovery, despite an enduring US west coast labor strike paralyzing 29 ports.
Considering weaker demand, China has to be put under the spotlight. China’s economic growth target for last year was set in March last year as 7.5 percent; it turned out that the actual growth rate was 0.1 percentage point short of the mark. In addition to the failure of fulfilling its annual goal, a 7.4 percent GDP growth rate signaled a new low for the second-largest economy in the world since 24 years ago.
Structural reform conducted by Beijing is hurting China’s internal demand growth, whereas its external growth has no choice but to rely on input substitution policy.
Besides China’s role, Europe and Japan play supporting roles in weaker demand. Europe and Japan have long-lasting debt issues to address; imposing expansionary fiscal stimulus is no longer among their options. Both of them are still fighting deflation with extremely slack monetary measures.
The Bank of Japan introduced its quantitative and qualitative monetary easing in April 2013, aimed at overcoming years of deflation and anchoring 2 percent inflation in just about two years from then. The European Central Bank (ECB) began its European-style quantitative easing in March by purchasing 60 billion euros (US$63.2 billion) of debt per month.
The ongoing easing by Japan and fresh easing by the ECB have strongly suggested that growth in these two economies remained tepid, and monetary operations were the obliged methods, due to the fiscal crisis. Ironically, the collapse of crude oil prices has further hobbled their efforts to cope with deflation.
In addition to weak demand, oversupply has played a critical role in driving down crude oil prices.
The introduction of shale oil fracking technology — widely recognized as an oil production revolution — helped shift out the supply curve. The technological advance has dramatically increased the supply of oil coming from the US.
Nevertheless, global oil prices are not simply decided by supply and demand equations, and the oil market is not in the slightest an example of perfect competition.
First, oil prices are determined in the oil futures market, mostly by speculators and to some extent by hedgers. The global oil market is an oligopoly, a well-known example from an economics 101 textbook. Furthermore, this oligopolistic market is dominated by nations with large shares of oil reserves.
With about 80 percent of world crude oil reserves, OPEC nations determine the quantity of oil to produce and maintain the most 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, thus keeping oil prices low. Phase one would be to push away Russia and its 14 percent share of world oil production.
With the continuous economic sanctions by the West on Russia for its invasion of 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 is from US$50 to US$75 per barrel.
Crude oil production among OPEC members — especially Saudi Arabia — 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 to reclaim market dominance from the US shale oil producers.
The US shale oil industry responded to collapsing crude prices by slowing its blazing growth and holding back expansion plans.
In addition to the weaker global demand and ample oil supply, a stronger US dollar is also pressing down crude prices. The US Federal Reserve has launched three rounds of quantitative easing measures since 2008.
The US easing generated a huge amount of so-called “hot money” flowing to emerging economies and commodity markets. The last round of easing ended in October last year, and the hot money began to return to the US.
Besides the easing moratorium, a potential hike in interest rates to further tighten US monetary policy has been rumored since the second half of last year. The US federal funds rate has been set at a range from 0 to 0.25 percent since Dec. 16, 2008.
A future rate hike would strengthen the greenback. As crude prices are denominated in the US dollar, a stronger dollar makes crude cheaper.
The crude price collapse takes a serious toll on oil producers; however, it is beneficial for Taiwan’s economy. Even though the production and trading of certain petrochemical industries were negatively impacted by the low oil prices, lower fuel and transport costs have helped promote overall industrial production and consumption in Taiwan.
What must be emphasized is the trend of future crude prices. According to the most recent forecast by the US Energy Information Administration, crude prices will gradually go back up to from US$60 to US$70 per barrel.
That means that Taiwan’s economy could be losing the luxury of lowered costs. Nevertheless, that could also imply a rebound in demand above and beyond the stories of supply side and dollar trends. That might not necessarily be a bad news after all.
Darson Chiu is the deputy director of the Taiwan Institute of Economic Research’s Macroeconomic Forecasting Center.
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