With the rise of Islamic extremism in the Middle East and Daesh (or ISIS, ISIL, IS, or whatever you want to call it) in control of oil fields in Iraq, one of the biggest surprises this year has been the plunge in oil prices. Although the decline actually began during the second half of last year, it picked up steam in 2015. Many analysts, including myself, were convinced that oil would find support somewhere around $60 per barrel. We were wrong. Today, one of the key crude oil benchmarks, West Texas Intermediate, is selling for less than $38 per barrel.
What happened? Basically, it’s a story of demand and supply. Too little demand and too much supply. However, I thought lower prices would quickly increase demand and reduce supply. Demand is indeed increasing, but not by enough to soak up all of the supply. That’s because contrary to expectations, lower prices have not reduced supply. One thing I didn’t count on was how determined some of the major producing nations, especially Saudi Arabia, were to let prices fall.
Many OPEC nations, including Saudi Arabia, the United Arab Emirates, Iraq and Iran, have extremely low marginal costs of production. So they can make a nice profit even if the prices fall well below today’s level. However, these countries require much higher prices in order to meet their budgetary commitments. As a result, I was convinced that they would not put up with low prices for long. I expected them to cut production and push the market price of oil back into the $60-80 per barrel range.