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“The Mystery of Oil Prices”, an article by Dr. Leonel Fernández

March 17, 2016

Over production by OPEC countries and a drop in demand from China has driven down the price of “black gold.” Although in recent weeks, prices have gone up again due to speculation in the futures market.

Since June 2014 up to February of this year, that is to say the last 20 months, crude oil prices have dropped 75%, from $108 per barrel to $26.

The reasons posited to explain why this happened include,
on the one hand, overproduction of oil leading to market saturation, and on the other, a slowdown in economic growth in China, resulting in a decrease in demand.

In other words: in accordance with the criteria put forth, what explains the recent brutal collapse in oil prices is the classic concept of the relationship between supply and demand, which dictates market behavior in a freely competitive economy.

In part, this is true. Overproduction has meant
that OPEC countries have nearly 32 million barrels on the market, and after the lifting of sanctions, Iran has increased its production to three million barrels a day, while Iraq produces 4.3 million barrels a day.

In the United States – as a result of the so-called shale gas revolution – production has risen from 4.6 million barrels per day in 2005 to 9.6 million today.

Moreover, at the moment, the United States has 508 million barrels of oil in
storage, which represents its greatest supply capacity in the past 80 years.

On the demand side, it is logical that with China’s GDP dropping from 12% to 6.5% and the country’s economy shifting from an export model to internally driven development, their oil capacity demand has gone down.

But if the fundamentals of the economy, that is supply and demand, are conclusive causes of the drastic drop in oil prices, why, in the face of
oversupply or declining demand, didn’t oil producing countries take measures to reduce production?

The US is interested in weakening Putin, forcing Iran into negotiations and wearing down Maduro

What is certain is that Saudi Arabia, in order to protect their own market shares, has sought to maintain their current production levels. With that, it is pushing oil prices down and competing with new North American shale gas
producers.

However, because of this policy, Saudi Arabia has seen their revenue fall, a drop in their reserves, as well as an increase in their deficit and debt. The fact remains that they have caused bankruptcy among many new US oil companies.

The bankruptcy of these North American companies has caused serious concerns in the financial sector. Banks have been exposed to the risk of not being able to pay back loans at the time when oil prices were above
$100 a barrel.

Also, for purposes of correlation, the collapse of oil prices has had an impact on stock markets, which have seen a drop in value of corporate shares in markets in Shanghai, New York, London, Hong Kong and Frankfurt.

But if that is the situation among new producers, the financial sector and stock markets, why hasn’t the US government intervened and pressured Saudi Arabia and other OPEC members to reduce production and,
consequently, raise oil prices?

Perhaps up to now, the US has had other priorities, such as geopolitical concerns aimed at lowering oil prices, causing a weakening of the Putin government following the Ukraine crisis, which is what is occurring now. The US is also involved in forcing Iran to negotiate its nuclear program, which was successful. And, to wear down the government of Venezuelan President Nicolás Maduro, which is also happening.

Fluctuation in prices is not due exclusively to the law of supply and demand

It is also likely that other variables have been taken into consideration in order to avoid taking measures to increase oil prices.

For example, it is possible that in the face of weak growth in the global economy, arising from the financial crisis unleashed in late 2007, it was thought that a drop in oil prices might create a stimulus for economic
recovery.

Be that as it may, what is certain is that in the face of the bleak picture created by a reduction in oil prices, countries such as Nigeria and Venezuela have pushed both Saudi Arabia and other OPEC countries to slow down production and encourage a rise in crude prices.

But the only goal that has been reached has been a freeze in oil production. This way, market factors that determine a reduction in oil prices, supply and demand, remain
unchanged, so that there would be no reason for a price increase.

However, in February, after having fallen to its lowest level since 2003, for the last two weeks the price of oil has risen by 32%, reaching over $ 34 a barrel.

The only thing that could really explain this new situation is the strengthening of the US dollar and participation in hedge funds, investment banks and insurance companies buying future contracts in oil stocks through financial
speculation.

This is what happened in 2008, when oil prices plummeted from $147 a barrel in June of that year to $30 six months later, without there being any change in normal market mechanisms.

Now we know that fluctuations in oil prices do not exclusively correspond to the laws of supply and demand. There are other factors involved, such as the new modality of financial speculation on futures contracts.

Therein lies the mystery of
oil prices.