Anyone within the United States who drives a car has surely been happy to note that as of late, the price of gasoline within the nation has dropped significantly. This, of course, has everything to do with the economics of supply and demand within the oil industry. While the recent reduction in oil prices must surely seem like a blessing from the perspective of the consumer, it has potentially negative ramifications from a broader perspective. This sample economics essay explores the reduction in the price of oil is doing more harm than good.
Description of the oil price situation
The empirical fact is that oil prices have dropped dramatically over the course of the past several months. This fact can be fully explained through a basic application of the macroeconomics of oil and principles of the laws of supply and demand. As Krauss has indicated, on the supply side:
“United States domestic production has nearly doubled over the last six years, pushing out oil imports that need to find another home;” and “on the demand side, the economies of Europe and developing countries are weakening and vehicles are becoming more energy-efficient” (paragraphs 5-6).
The fact that the United States is producing its own oil practically means that from the global perspective, the demand for oil has fallen; and this has forced foreign oil producers to cut their prices in their search for a new market for the oil that was previously consumed by the United States. This is exacerbated by the fact that demand is also falling in a more direct way as a result of economic and technological developments in nations that have historically been heavy consumers of oil.
OPEC and other international factors impacting oil prices
One of the main points that have contributed to the ongoing low price of oil is the fact that the organization known as OPEC, which is composed of the primary oil-exporting nations in the world, declined to cut back on oil production as a means to make the prices go back up (see Zhdannikov).
In terms of supply and demand, if OPEC had stopped producing so much oil, then this would have decreased the supply of oil and increased its scarcity; and this would have increased the relative value (i.e. the price) of oil. OPEC, however, has opted to simply continue producing oil at normal rates, merely affirming that the prices will eventually go back to normal on their own as a result of the natural workings of the global economy.
One theory for why OPEC has made its decision has been expressed by Al Mulla:
“Some argue that Saudi Arabia, the world’s largest [oil] producer, is defending its market share by cutting prices rather than production. Others would go so far as to say that Saudi Arabia is pushing prices down to hit its regional rival Iran” (paragraph 6).
In essence, if OPEC were to cut production, then the relative proportion of oil in the world produced by OPEC would obviously go down; and OPEC may strategically believe that it is more important to maintain a consistent market share than it is to take efforts to make the price of oil return to normal in the short term. There would thus seem to be a significant political dimension to OPEC’s decision.
It cannot be explained strictly by the laws of supply and demand because those laws would suggest that the rational self-interest of OPEC would require the organization to cut spending. If this is not happening, then clearly it is because there are other interests that OPEC is pursuing aside from simple short-term profit.
Oil and the global economy
The first main reason why the recent reduction in oil prices is not a good thing is the fact that it is significantly destabilizing the global economy. For example, Russia is one of the nations that has been hit hardest by the price drops. As Bowler has written:
“Russia loses about $2bn in revenues for every dollar fall in the oil price, and the World Bank has warned that Russia’s economy would shrink by at least 0.7% in 2015 if oil prices do not recover” (paragraph 5).
This problem has been exacerbated by the sanctions that have been levied against Russia by the Western world as a result of the current diplomatic situation in the Ukraine. The Editors of The Economist have also indicated that:
“protests driven by economic and also social issues have already started. Even in Moscow where the mood for protest is low, teachers and doctors have come out onto the streets to protest the pay cuts and restructuring” (last paragraph).
International economies conflict with oil prices
Something similar can also be said about the situation in Venezuela, another major producer of oil. It seems that if the current oil price drop continues, there is a significant risk that the nation may need to default on its debts because balancing the national budget requires oil prices to remain at a certain designated level (see Bowler).
This is a more general problem for all OPEC nations, which have surely created their budgets under the assumption of normal circumstances and not the extraordinary reduction that has taken place over the past several months. The instability caused by the situation could have geopolitical consequences, as is already being seen in Russia. Such instability would in all likelihood not have good consequences from the perspective of American foreign policy.
Moreover, it is worth pointing out that the instability is exacerbated by the fact that oil-producing nations are essentially in a situation in which they have no choice but to engage in economic behaviors that cause them harm. For example, Bowler has pointed out that Russia is not planning on cutting back on its oil production even as the currents prices are far too low to sustain the nation’s economy.
This would seem to be because of the perception that however bad the situation is for Russia at the present time, it would become even worse if Russia were to cut back on its production, because this would imply the sacrifice of market share, which would hurt the national economy not only in the short term but also over the long term. There is thus a kind of double bind in place, which causes the situation to evolve in an exorable way: in essence, there is nothing nations can do to stop the situation from becoming gradually worse.
Oil prices seen strategic threat
Turning to the second point of the present argumentative essay now, it must be pointed out that the current drop in oil prices actually threatens the oil industry within the United States itself. Shale oil production within the United States recently turned to fracking and has dramatically increased productive capacities within the nation. Using fracking to increase production is actually one of the key factors contributing to the current low price of oil. However, if prices remain as low as they are, then it may eventually become unprofitable for companies within the United States to continue producing oil.
This would result in those companies going out of business, which would then result in an increase in the prices of oil since the United States would need to begin importing oil again (see Tully). This would also result in an expansion of the market share of the OPEC nations to what it was before the United States began producing oil. In effect, if things keep going as they presently are, then the results of expanded oil production within the United States may end up canceling the necessary conditions for ongoing production.
OPEC’s perceived attack against American oil interests
Seen in this light, it becomes clear that OPEC’s decision to not halt oil production can actually be interpreted as an attack on the oil industry within the United States. Essentially, the OPEC strategy would consist of absorbing losses over the short term in order to drive smaller rivals out of the business, at which point companies within the OPEC nations will be able to enjoy both higher prices and expanded market share.
The fracking and oil production capacities of the United States are relatively young, the relevant companies would not be able to sustain losses for as long a period of time than their counterparts in the OPEC nations. This provides a good explanation for why nations such as Saudi Arabia have clearly prioritized market share over higher prices in the short term: it is because if they play their cards correctly, then the nations may be in a position to reap both benefits (and not just one or the other) in the long term.
It is perhaps worth noting the counterargument that:
“the recent drop in crude prices won’t kill off the US shale oil industry. It’ll just make it more efficient” (Sanati, paragraph 1).
The idea here is that since the profit margin will be narrower, American companies will rise to the challenge by optimizing their operations. There is surely some wisdom in this; however, it must be stated that such optimism will only be valid insofar as the prices do not drop even further than they have thus far, and insofar as they do not remain this low for an extended period of time.
There is clearly a point past which American companies will no longer be able to continue producing oil, but past which the OPEC nations will be able to continue producing without any problems. The low prices in the United States, then, while good from the consumer’s perspective, is potentially disastrous from the producer’s perspective. The low prices are a threat to the entire domestic oil industry within the United States; and if this burgeoning industry collapses, then consumers will also feel the negative repercussions soon enough.
Low oil prices breed false expectations
Finally, the point can also be made that the current low prices of oils may have the negative effect of breeding false expectations in Americans. For example, Americans may come to accept the impression that oil is not a scarce resource after all (since it is available for so cheap), or that it is not necessary to seriously begin developing alternative modes of energy (among other reasons, to help avert the catastrophe of global warming).
Perhaps Americans who would have opted for public transportation now drive their cars instead as a result of being able to afford this. In short, the low prices of oil are reflective neither of the sustainability of oil as an energy source nor the actual long-term availability of oil on the planet. Unlike wind and other cleaner energy sources, oil is intrinsically a diminishing resource (i.e. there is only a finite amount on the planet), which means that prices will rise again sooner or later.
In the grand scheme of things, then, the present situation can only be described as anomalous. The supply of oil is steadily and necessarily diminishing, which means that according to the laws of supply and demand, there is no way that oil will not (on the balance) become steadily more expensive over time. Perhaps there is nothing wrong with Americans enjoying the low prices while they last, as long as they remain fully aware of the fact that this is not the new norm and that one way or the other, the prices are not going to last.
In summary, this essay has consisted of an argument regarding why the recent price reduction in oil cannot be seen as primarily a good thing. Three points were made in this regard. Firstly, the price drop is causing chaos across the global economy; secondly, the price drop can be interpreted as a strategic effort on the part of OPEC to push American oil companies out of the market; and thirdly, the price drop does not reflect the actual status of oil in the world and may thus create false expectations in the minds of Americans. For all these reasons, the conclusion can be reached that the net effect of the price drop on America is a negative one.
Al Mulla, Habib. “Why Are Oil Prices Dropping?” Forbes. 24 Nov. 2014. Web. 24 Jan. 2015. http://www.forbes.com/sites/realspin/2014/11/24/why-are-oil-prices-dropping/.
Bowler, Tim. “Falling Oil Prices: Who Are the Winners and Losers?” BBC. 19 Jan. 2015. Web. 24 Jan. 2015. http://www.bbc.com/news/business-29643612.
Editors. “Russia: The End of the Line.” The Economist. 22 Nov. 2014. Web. 24 Jan. 2015. http://www.economist.com/news/briefing/21633816-more-decade-oil-income-and- consumer-spending-have-delivered-growth-vladimir-putins.
Krauss, Clifford. “Oil Prices: What’s Behind the Drop? Simple Economics.” New York Times. 12 Jan. 2015. Web. 24 Jan. 2015. http://www.nytimes.com/2015/01/13/business/energy- environment/oil-prices.html?_r=0.
Sanati, Cyrus. “Oil Price Drops: Don’t Panic, Really.” Fortune. 8 Dec. 2014. Web. 24 Jan. 2015. http://fortune.com/2014/12/08/oil-prices-drop-impact/.
Tully, Shawn. “The Shale Oil Revolution Is in Danger.” Fortune. 9 Jan. 2015. Web. 24 Jan. 2015. http://fortune.com/2015/01/09/oil-prices-shale-fracking/.
Zhdannikov, Dmitry. “OPEC, Oil Companies Clash at Davos over Price Collapse/” Reuters. 21 Jan. 2015. Web. 24 Jan. 2015. http://www.reuters.com/article/2015/01/21/us-opec-oil- davos-idUSKBN0KU21720150121.