Some thoughts on the current drop in OIL price

The classic question of what came first, ‘the chicken or the egg?’ could be argued in the current massive drop in oil price. No one that I can find, and I doubt that anyone can prove me wrong, expected such a massive 35% drop in the oil price 5 months ago. Analysts are forced to explain this unexplainable event and they point towards the increase in supply from primarily e.g. Saudi Arabia, which is a verified fact.

However, could this relative small increase in supply be the sole explanation for such a massive price fall given that the global economy is still growing and the demand for oil over the past years have increased rather than decreased? The answer I believe is no, which leads me to the use of derivatives.

Let us assume that the derivatives market is the chicken in this case. The derivatives market is controlled by banks and is far larger in numbers (money quantity) than the real market (that is driven by supply and demand, in this case of oil). This means that the derivatives price will ultimately set the real oil price, not the other way around. New oil projects are extremely costly and are therefore funded by either bank loans or via bonds on the financial markets (oil projects are considered high risk projects). The oil fields rights are used as debt collateral. If these fields become unprofitable, the oil company will “throw in the key” so to speak and the banks or the investors will own the oil fields rights. It is safe to assume that if this low oil price continues, more and more fields will be shot down which will have a direct negative effect on oil supply.

The other side of this story is the egg, in this case the real economy consisting of supply and demand for oil. For the demand to decrease we need to be in a global recession (IMF expects a global growth at 3.3 percent for 2014 published October 7th 2014 ), so let us focus on the increase of supply scenario. The major oil-producing countries such as Saudi Arabia are rather unstable and their economy is dependent on oil exports. These countries subsidize the domestic price of gasoline, which has become increasingly more expensive due to domestic growth and domestic oil demand. This leads to less oil for exports that will provide income to keep their economy going. Given a drop in oil price these countries are forced to increase the oil production in order to avoid an economic meltdown. If the oil price remains low, it could potentially trigger a domestic economic crisis and civil unrest within the oil-producing countries, which would then ultimately lead to a global decrease of oil supply.

So the question is what came first, the egg or the chicken? Since the derivatives market ultimately sets the price of oil due to its mere size, it may well be the chicken that came first, forcing the oil producing countries to increase production by pushing down the price. If it maintains at these low levels, supply could get hit twice due to closed oil fields and geopolitical instability in oil producing countries causing the biggest energy crisis so far. Banks and investors without any experience in advanced oil drilling will end up owning rights to a lot of oil fields. Food prices will potentially sky-rocket and hyperinflation would threaten the existing petrodollar-based monetary system.

So, the current drop in oil prices might ironically trigger an enormous energy crisis that threatens the existing global monetary system.


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