Background
From Figure 1, crude oil prices has been falling steeply over the past few months, due to global oil supply increasingly outstripping global demand with an increase in the number of suppliers.
Figure 2 shows the supply and demand changes due to the increase in the number of suppliers, causing the old supply curve to shift rightward. The equilibrium price falls from P1 to P2. This accounts for the steep fall of oil prices. |
OPEC's Actions
As a cartel, OPEC has the role to lower its oil production when global oil supply is too much, in order to stabilize prices.
Lowering the oil production will cause the supply curve to shift leftward in Figure 2, causing prices to rise, stabilizing the price.
But OPEC did not lower the price.
Lowering the oil production will cause the supply curve to shift leftward in Figure 2, causing prices to rise, stabilizing the price.
But OPEC did not lower the price.
Reasons
1. Maintaining their Monopoly
OPEC wants to maintain its global market share of oil supply.
Due to the widespread adoption of horizontal multi-stage fracking techniques, total oil production in the U.S. has surged from just over seven million barrels of oil per day at the beginning of 2013 to more than nine million barrels in Feb 2015. Hence, OPEC is losing their monopoly.
Also, OPEC did lower its oil supply when global oil supply is high in the past few decades, causing their global market share of oil to have fallen from about 50% in the 1980s to about 33% today.
Thus, this time round, OPEC has decided not to cut its supply of oil so as to protect and prevent its global market share from diminishing any further.
2. Engage in Predatory Pricing
Understanding Predatory Pricing
As OPEC is a dominant player of the oil market, it can choose to keep oil prices at very low, even to loss-making levels in order to force rivals or other competitors to cut their supply of oil. And once these competitors have been 'driven out', OPEC can raise its prices, perhaps to monopoly levels to increase profits. This aggressive and strategic move is known as predatory pricing. It uses price as a barrier to entry of any potential entrant to the market.
Gaining the ability to set low prices
OPEC is able to do so as the costs of producing oil in OPEC countries are generally much lower than the costs of producing oil in non-OPEC countries. For example, Saudi Arabia's cost of oil production is far lower ($10 - $15/ barrel) when compared to USA's shale extraction costs ($50-$70/ barrel).
Out sustaining non-OPEC countries
By setting prices that would incur losses, OPEC can make oil production unprofitable in some non-OPEC countries, forcing them to cut down on their oil supply. Whereas on the other hand, OPEC can sustain and survive low prices for periods of time longer than the non-OPEC countries, eventually outlasting these countries. It is reported that the U.S shale oil industry output will record its first monthly decline in May 2015, after 4 years of continual positive increase.
3. Prior Experience
Saudi Arabia, the most powerful and influential of the 12 OPEC countries, seems mindful of the experience of the 1980s oil glut.
Background of the Oil Glut
It was a period of time that had serious surplus of crude oil caused by falling demand after the 1970s Energy Crisis. The world price of oil fell greatly. The new oil prices prompted huge investments in new fields of extracting oil in many other countries, leading to a decade-long oil glut.
Impact on Saudi Arabia
Saudi Arabia's oil exports fell from 9.6 million barrels a day in 1980 to 2.8 million in 1985. In contrast, non-OPEC's oil exports increased greatly.
Lesson Learnt?
This time round, Saudi Arabia seem to be pushing a different tactic: let the price fall and drive out high-cost oil producers so that the supply of oil will decrease, and prices eventually rising again.
4. Economic War
This decision by OPEC might be due to political tensions between Saudi Arabia, the larger oil exporter in OPEC, and the USA.
Consequences of this decision
One of the consequences to this problem is many oil companies in the USA will be forced to shut down. Considering Total Profit = Price - Cost of a good, if the Price decreases and the Cost remains constant, the Total Profit will fall. This may cause companies to lose money, and eventually have to shut down.
Furthermore, if these films shut down, OPEC will gain a greater monopoly over the market of oil.
This will make the demand curve for oil be even steeper, and the price elasticity of oil will fall. OPEC will stand to have greater profit.
Political Perspective
If these oil companies were to shut down, the economy of the US will not do as well. On the other hand, driving out competitors will give Saudi Arabia and OPEC greater profits, letting their economy grow. This situation is akin to an economic war by Saudi Arabia.
*Note: This is just an opinion / analysis. We don't mean to start a war.*
OPEC wants to maintain its global market share of oil supply.
Due to the widespread adoption of horizontal multi-stage fracking techniques, total oil production in the U.S. has surged from just over seven million barrels of oil per day at the beginning of 2013 to more than nine million barrels in Feb 2015. Hence, OPEC is losing their monopoly.
Also, OPEC did lower its oil supply when global oil supply is high in the past few decades, causing their global market share of oil to have fallen from about 50% in the 1980s to about 33% today.
Thus, this time round, OPEC has decided not to cut its supply of oil so as to protect and prevent its global market share from diminishing any further.
2. Engage in Predatory Pricing
Understanding Predatory Pricing
As OPEC is a dominant player of the oil market, it can choose to keep oil prices at very low, even to loss-making levels in order to force rivals or other competitors to cut their supply of oil. And once these competitors have been 'driven out', OPEC can raise its prices, perhaps to monopoly levels to increase profits. This aggressive and strategic move is known as predatory pricing. It uses price as a barrier to entry of any potential entrant to the market.
Gaining the ability to set low prices
OPEC is able to do so as the costs of producing oil in OPEC countries are generally much lower than the costs of producing oil in non-OPEC countries. For example, Saudi Arabia's cost of oil production is far lower ($10 - $15/ barrel) when compared to USA's shale extraction costs ($50-$70/ barrel).
Out sustaining non-OPEC countries
By setting prices that would incur losses, OPEC can make oil production unprofitable in some non-OPEC countries, forcing them to cut down on their oil supply. Whereas on the other hand, OPEC can sustain and survive low prices for periods of time longer than the non-OPEC countries, eventually outlasting these countries. It is reported that the U.S shale oil industry output will record its first monthly decline in May 2015, after 4 years of continual positive increase.
3. Prior Experience
Saudi Arabia, the most powerful and influential of the 12 OPEC countries, seems mindful of the experience of the 1980s oil glut.
Background of the Oil Glut
It was a period of time that had serious surplus of crude oil caused by falling demand after the 1970s Energy Crisis. The world price of oil fell greatly. The new oil prices prompted huge investments in new fields of extracting oil in many other countries, leading to a decade-long oil glut.
Impact on Saudi Arabia
Saudi Arabia's oil exports fell from 9.6 million barrels a day in 1980 to 2.8 million in 1985. In contrast, non-OPEC's oil exports increased greatly.
Lesson Learnt?
This time round, Saudi Arabia seem to be pushing a different tactic: let the price fall and drive out high-cost oil producers so that the supply of oil will decrease, and prices eventually rising again.
4. Economic War
This decision by OPEC might be due to political tensions between Saudi Arabia, the larger oil exporter in OPEC, and the USA.
Consequences of this decision
One of the consequences to this problem is many oil companies in the USA will be forced to shut down. Considering Total Profit = Price - Cost of a good, if the Price decreases and the Cost remains constant, the Total Profit will fall. This may cause companies to lose money, and eventually have to shut down.
Furthermore, if these films shut down, OPEC will gain a greater monopoly over the market of oil.
This will make the demand curve for oil be even steeper, and the price elasticity of oil will fall. OPEC will stand to have greater profit.
Political Perspective
If these oil companies were to shut down, the economy of the US will not do as well. On the other hand, driving out competitors will give Saudi Arabia and OPEC greater profits, letting their economy grow. This situation is akin to an economic war by Saudi Arabia.
*Note: This is just an opinion / analysis. We don't mean to start a war.*