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Rigged Prices

News & Features | February 3, 2015

During last week’s State of the Union address, as President Barack Obama boasted about the United States’ energy independence, a fancy, graphic-laden split screen displayed the number $1.99. With dramatic drops in oil prices over the last few months, this is the new national average for a gallon of gas, a figure that would have been inconceivable a few years ago when turmoil in the Middle East sent the price skyrocketing above $4.00 in most states. The oil price has fallen by more than 40 percent since June, when it was $115.00 a barrel. As of January 27, the price has dropped to $45.00 a barrel.

As Tufts Political Science Professor Nimah Mazaheri explains, “Crude oil is traded at a futures exchange, where buyers and sellers come with their orders for future delivery. Depending on their particular needs and how fast they need to buy or sell oil, they will agree to a price.” However, projections about the health of the global economy, predictions of weather patterns, news about recent oil discoveries and changes in consumption patterns also affect the price. National security issues of war or terrorism often threaten the oil supply, much of which comes from the Middle East.

There is one other crucial determinant of oil prices: the Organization of the Petroleum Exporting Countries (OPEC), which controls nearly 40 percent of the world market. OPEC’s decisions shape expectations, which will affect the world price. If OPEC curbs supply sharply, it can send prices spiking.These can be simple questions of supply and demand, until politics get in the way.

Faced with a deluge of new oil supply, mainly from U.S. shale production, OPEC met in Vienna on November 27 to determine new production quotas. “OPEC has been losing power to control the oil market as a result of the increase in oil production by non-OPEC countries,” says Tufts Economics Professor George Norman. Analysts had estimated OPEC would need to take 1 million to 1.5 million barrels a day off the market to support oil prices, which had fallen by more than 30 percent since the summer.

While the various geopolitical and social motivations can be hard to follow, it appears as though a group of Arab Producers of the Persian Gulf formed within OPEC, an internationally and legally recognized cartel. This alliance, centered on Saudi Arabia, which produces nearly 10 million barrels of oil a day—a third of the OPEC total—refused to agree to the production standards put forth by other OPEC nations like Russia and Venezuela. The Saudis and their Gulf allies decided not to sacrifice their own market share to restore the price. They could curb production sharply, but the main benefits would go to countries they detest, such as Iran and Russia. With a reserve fund of $900 billion, Saudi Arabia can afford to tolerate lower oil prices for eight years, according to former Saudi Arabian advisor Mohammad al-Sabban. Its own oil costs around $5.00 – $6.00 per barrel to extract from the ground. Meanwhile, in the United States it can cost roughly $85 to extract one barrel. OPEC failed to reach agreement on production curbs, sending expectations into turmoil and prices tumbling even further, with prices being cut in half.

In the months since, dropping prices have produced a number of winners and losers in the oil industry. With sanctions compounding the tumbling oil prices, Russia, a country whose economy relies heavily on oil and gas exports, has fallen into recession. Saudi Arabia has shown concern too, but seems assured that its cash reserves can weather a long period of depressed prices.

The country left most in uncertainty by Saudi Arabia’s actions and falling oil prices is the United States of America. On a personal level, consumers are benefitting in the short term. According to Professor Mazaheri, “Lower oil prices are a positive turn of events for most Americans, who are used to spending about 4 percent of their annual income on gasoline. For low-income households with a car, lower gas prices are a great help to their budgets and are coming at a much-needed time.” Lower gas prices will also be a major benefit for any energy-intensive industrial sector in the United States. “If prices remain low into the summer, they should benefit the agricultural sector and farmers who rely on fuel and energy-based fertilizers and pesticides,” says Professor Mazaheri.

The oil industry may not be sharing the optimism of the farming industry. Recent shale oil and natural gas booms have led to thriving economies in new frontiers like North Dakota and Wyoming, a modern day gold rush providing jobs to the country and a vast new supply of oil to the world market. But with prices now in flux, so too are oil producers. “Generally, decisions about exploration and production are made over the long-term and assume that price fluctuations will occur and so the vast majority of these companies are prepared for a drop in prices,” Professor Mazaheri explains. Volatility is the nature of the oil market. “Recently, some US oil rigs have responded to the low prices by cutting back in drilling, but this has been a small segment of producers and has not affected overall US production. As of today, it appears that the price is not low enough where this would have a major impact on production.”

Unfortunately, Professor Mazaheri notes, “Smaller producers extracting harder-to-get oil would be forced to consolidate or close down.” Often times these smaller producers are found in states where the oil industry isn’t as well established. A study published in 2013 by the Council on Foreign Relations suggested that job losses from a sharp decline in oil prices would be largest in Wyoming, Oklahoma and North Dakota, states with recently expanded oil industries due to developments in fracking technology.

As reported by the New York Times, Louisiana is also feeling the strain. With an economy that is smaller and less diversified in comparison to oil juggernauts like Texas, Louisiana has had to eliminate positions in the state government, reduce contracts across the state and halt expenses for excess items at all state agencies. According to Greg Albrecht, Louisiana’s chief economist, Louisiana loses $12 million for every $1.00 in decline in the annual average price of a barrel of oil.

While oil producers and consumers alike remain rooted in uncertainty and apprehension, recent months serve as a concrete reminder of the volatility of oil. Because oil as a resource is highly politicized, subject to constant scrutiny and geopolitical conflicts, fluctuating oil prices are nothing new. And despite its flaws, OPEC has long maintained its ability to coordinate production levels and restore prices. But with technology rapidly changing the ways we extract oil, and jockeying for market dominance fragmenting OPEC’s cohesiveness, oil producers are in a more vulnerable state than ever before. Thankfully, oil-producing states have diversified their economies, becoming far less dependent on oil and gas tax revenue than they were 30 years ago. The current situation could have been much worse. The portion of the state budget in Louisiana linked to oil and gas revenue is about 13 percent, compared with 45 percent in the 1980s.

However, for much of the last few months, it seemed as though, more so than Russia, or Saudi Arabia, or the United States of America, the environment was the biggest loser in the recent oil boom. Developments in fracking technology made puncturing the earth’s surface cheaper and easier. Toxic oil processing plants are thriving, treating more oil than ever before. With gas priced so low, consumers have no incentive to switch to energy-efficient alternative forms of transportation. The struggles of states like Wyoming and Louisiana demonstrate the ongoing need for a dependable, consistent, form of clean energy for the future.

As it stands, the world’s reliance on oil leaves it subject to the constant fluctuating nature of the oil economy.

Icon by Lloyd Humphreys. Header image by Kate Scheer.