By Robert J. Samuelson

Understanding the oil crash

The great oil bust of 2014 is something to behold. Since the middle of June, crude prices have dropped roughly 40 per cent - to US$70 a barrel for the Brent benchmark, from US$115.

US petrol prices have fallen almost a dollar a gallon, from US$3.63 in June to US$2.74 early this month.

These declines signal a massive transfer of wealth from producers to consumers, estimated at US$1.5 trillion (S$1.96 trillion) annually by economist Edward Yardeni.

Although the full implications are hazy - in part because it is unclear where prices will settle - likely effects include a boost to the sluggish global economic recovery and political strains for some major exporters, including Iran, Nigeria, Russia and Venezuela. Why are prices falling? What does it mean? This is what we know.

  • The law of supply and demand did it. The price collapse mainly reflects too much supply chasing too little demand.

Most analysts have focused on surging production in the United States of shale oil, which has risen by 3.5 million barrels a day (mbd) since 2008, according to the consultancy IHS.

But the US expansion was widely anticipated, says economist Larry Goldstein.

The real surprise, he argues, was lower-than-expected global demand. Early this year, forecasters predicted growth of 1.3 mbd, says Mr Goldstein. Actual growth is about half that, 700,000 mbd, reflecting unpredicted economic weakness in Europe, Japan and China.

  • The small shift in the supply-demand balance resulted in significant price changes, because oil demand is "price inelastic".

Modest surpluses and shortages can trigger dizzying price swings, because consumers' needs - in the short run - are rigid. Shortages cause a scramble for supply; surpluses lead to price plunges. As it is, global oil consumption is about 92 mbd today and available output capacity is about 95 mbd.

  • Lower prices, if maintained, represent a huge consumer windfall.

All countries that are net oil importers (most of Europe, Japan, China) should benefit, but the US - given its driving and flying habits - should be an especially big winner.

If crude prices fall an average US$25 a barrel, typical households could save US$500 over the next year, says Moody's Analytics economist Mark Zandi. Assuming two-thirds of the windfall is spent, the economy would grow 0.4 per cent faster (that's about US$70 billion in a US$17 trillion economy) and generate 350,000 jobs.

  • Cutbacks in oil exploration and development shouldn't offset most of this stimulus. In theory, low prices could cause oil companies to scrap new projects because they've become unprofitable. This would dilute the effect of higher consumer spending.

But for US shale oil, the threat is modest, argues IHS' Mr Daniel Yergin in The Wall Street Journal. He cites an IHS study, based on individual well data, finding that 80 per cent of projects planned for next year are profitable with oil prices between US$50 and US$69 a barrel. (IHS assumes prices will stabilise at US$77 a barrel.)

Longer term, low prices would threaten costly deepwater and Arctic projects, Mr Yergin says. But the effect would be gradual.

  • Opec (the Organisation of Petroleum Exporting Countries) is not a working cartel.

Cartels prop up prices by limiting supplies. If Opec's members - representing a third of global oil output - were a genuine cartel, they would have prevented the price collapse. Opec did not because, says Mr Goldstein, almost all its members want "to produce every barrel they can". Only Saudi Arabia, its largest member, would trim production to raise prices. It refused to shoulder single-handedly the costs of being a cartel.

It is unclear how far prices may sink or when they might rise. For many producing nations, oil revenues constitute a sizeable share of government budgets.

Will the squeeze cause social strife or political instability? Will it spur some (Russian President Vladimir Putin?) to become more bellicose to distract from a faltering economy? Will the damage cause Opec to behave like a real cartel?

The oil crash is a big story this year. It might be even bigger next year.