Will oil prices rise in 2016?

Oil prices are currently around US$35. It is virtually public knowledge that the slide in oil prices from US$115 in June 2014 to the current level is due to a combination of events, namely the increase in shale oil production in the United States and the increase in crude oil production in OPEC, particularly in Saudi Arabia. Accordingly, oil prices will rise when shale oil production in the United States or crude oil production in OPEC decrease. However, both scenarios are unlikely, at least in 2016.

Some people have been wondering why OPEC, particularly Saudi Arabia, has persistently refused to reduce crude oil production to increase oil prices which will lead to an increase in government revenue and export revenue due to the price inelastic nature of the demand for oil. It is true that a cut in crude oil production in OPEC will reduce the world supply of oil, as OPEC accounts for about 40 percent of the world supply of oil, resulting in a rise in oil prices. However, doing so will increase the profitability of shale oil production in the United States which will induce the U.S shale oil producers to increase production. This will lead to an increase in the world supply of oil resulting in a fall in oil prices. If this happens, oil prices will be back to the same level, but with one difference, OPEC will have a smaller market share and the U.S. shale oil producers will have a larger market share. This is the reason why OPEC has persistently refused to reduce crude oil production to increase oil prices. Instead of cutting crude oil production, OPEC has been increasing crude oil production to increase market share and to decrease oil prices with the objective of drive the U.S. shale oil producers out of the market. Although this will lead to a fall in government revenue and export revenue in the short term, it is a short-term-pain-and-long-term-gain strategy. This is particularly a good strategy for Saudi Arabia in view of the huge amount of reserves that the government possesses. Therefore, OPEC is unlikely to reduce crude oil production.

There are 39 shale oil fields in the United States with an average cost of production in the region of between US$70 and US$80. At the current oil prices of around $35, the shale oil producers in the United States are making a loss. The question is, why are they not closing down? One simply needs to take a closer examination of the cost of shale oil production to find the answer. Although the average cost of shale oil production is higher than the current oil prices, a large proportion of it is in the form of fixed costs, namely the costs of the machinery. In an Economics 101 class, one will learn that a firm will only consider variable costs when making output decision. If the price is higher than the average variable cost, the firm should continue production, even if this means making a loss. This is because the excess of the price over the average variable cost can be used to partially offset the average fixed cost resulting in a small loss. This is exactly the case in shale oil production in the United States currently. Although the average cost of shale oil production is higher than the current oil prices, the average variable cost is lower than the current oil prices. However, machinery is subject to wear and tear. Therefore, in time to come, the machinery which used in shale oil production will need replacement which point, all costs will become variable. If oil prices remain at such depressed levels at the point, the shale oil producers in the United States will close down. If this happens, the world supply of oil will decrease which will lead to a rise in oil prices. However, the machinery which is used in shale oil production can last at least five to ten years. Therefore, the shale oil producers in the United States are unlikely to close down soon, at least not in 2016.

In conclusion, oil prices are unlikely to recover soon, at least not in 2016. Oil prices are a major determinant of the cost of production in the economy and therefore will be discussed in great detail in the economics tuitionΒ class.

 

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