As most people have noticed in the news—and, even better, in the falling gas prices—oil prices have been plummeting drastically this year beginning in June. While this is great news for consumers who are going to save lots of money on gasoline with some prices at the pump dropping to as low as $2 per gallon of regular unleaded (I filled up my tank the other day for $30, almost unbelievable), this price plummet is a serious problem for countries who are dependent on their oil exports for economic stability (namely, Russia and Venezuela) and who don’t have the economic fortitude to be able to ride out these extremely low prices for very long before the threat of economic disaster becomes imminent.

 

Why Oil Prices Began to Fall

Since 2011, oil prices were primarily stable, floating around the $110/barrel mark. Since that time, prices have dropped as much as 50% to $59/barrel. This is a huge shock in the market and many analysts now believe that these low prices could continue deep into 2015.

Now, why were oil prices so stable between 2011 and June of this year? A couple of reasons. Looking back to the graph of the price of Brent Crude Oil over the last 10 years, we can see that prices rose until they reached a record high around 2008, then dropped drastically during the financial crisis, before rebounding up to 2011 during the economic recovery and remaining relatively stable until this year.

 

Up until 2008, rapidly increasing consumption of oil in China drove global demand up while global supply through oil production was unable to keep up, thus driving prices higher and higher. However, these increasingly high prices also meant that higher-cost producers in countries such as the U.S. could start drilling in harder to reach, more expensive areas such as in North Dakota and Texas shale formations.  Prices stabilized as demand for oil in the U.S. and EU began to taper due to more energy efficient economies in both regions and the increased supply by the higher-cost producers in regions such as the U.S. and Canada did little to decrease prices because tensions in the Middle East with an unstable Iraqi government, war-torn Libya, and economically crippled Iran producing an increasingly smaller share of world oil production, essentially evening out the U.S. and Canadian impact on the market.

 

However, this trend would not last very long. Soon, many of the disruptions in production that had lowered global supply of oil began to ebb. Libya began to export oil once more and consumers in the U.S. and Europe who had just made their way through a long recession that was still having lasting effects on their respective economies had factored in the consistent, high prices of oil into their long-term economic calculus and began to cut back their use, buying smaller, more fuel efficient cars and consuming less energy. These factors, along with economic slowdowns in China beginning in 2012 would create a situation where global supply was rising and global demand was falling. And, as even the most rudimentary microeconomics courses teach, this divergence between supply and demand would force prices down, reaching about $75 by the end of November, a 32% decrease since 2011.

 

OPEC’s Response

The Organization of Petroleum Exporting Countries (OPEC), an oil cartel which produces 40 percent of the world’s supply of oil, met at the end of November and faced the decision of what to do in response to the falling oil prices. Obviously, it would be in the interest of the organization and its members—whose economies are heavily founded on oil exports—for oil prices to remain high. Thus, many analysts assumed that OPEC would vote to reduce production, thus artificially constricting supply and raising prices once again. Many of its members including Venezuela and Iran wanted the organization—particularly Saudi Arabia who, with the UAE, account for 40% of OPEC’s supply—to cut production in order to raise prices and save their economies from collapse.

However, Saudi Arabia and the United Arab Emirates actually decided against cutting their production, instead calling on other producers to cut their supply if they wished. There are a few different possible reasons behind this decision. First, Saudi Arabia more than other countries such as Venezuela, Iran, and Russia can survive off of the lower oil prices without devastating effects to their economy in the short run, stating that they can survive at least two years with the new, low prices, thanks in part due to the country’s $750 billion in foreign-exchange reserves. The Saudis also likely did not want to cut production in order to prevent a repeat of the 1980s where low oil prices combined with their decision to cut production resulted in even lower prices and a loss in market share for Saudi oil. The Saudis are now placing their bets that, while they can survive these low prices for the foreseeable future, new, high-cost exporters that are driving up supply in the market such as the U.S. and Canada won’t be able to keep up. Indeed, U.S. revising down crude-oil output outlooks for 2015 and beyond. Essentially, the Saudis have initiated a price war between OPEC and the U.S. with the hope that they can run the high-cost producers out of the market with the low oil prices, pushing supply down and prices up without having to risk losing their own market share. It still remains uncertain how the U.S. oil producers will behave, but, for now, U.S. oil production still looks to be growing for 2015 despite producers already beginning to pull out of certain high-cost drilling projects

With this battle over the course of OPEC’s production, the organization decided to maintain their current output, with OPEC Secretary-General Abdalla El-Badri stating, “We will produce 30 million barrels a day for the next 6 months, and we will watch to see how the market behaves.” With this decision, the price of oil began to once again free-fall. As of this writing, prices are hovering slightly less than $60/barrel, a crucial cut-off point for many U.S. oil projects.

 

How These Prices Will Affect Nations

While we have covered how these low prices are intended to affect the U.S. and other high-cost producers, members of OPEC are also going to feel some pain because of the organization’s decision not to cut output.

Russia is already feeling this pain deep in their economy. Russia’s economy prior to this drop in the price of oil was already weak, with slow growth and a weakening ruble. Now, the economy is in shambles with the drop in oil prices putting even more increased downward pressure on the Russian currency. The ruble dropped nearly 50% versus the U.S. dollar and Apple even stopped selling products in their Russian online store for a number of days while they waited for the currency to stabilize. Though the currency appears to have stabilized now, deep economic troubles lie ahead for Russia with consumers having much less market buying power than they had before and the issues of having a broad economic impact on the Russian economy. If the prices stay low, the Russians may have to decide between using up their $74 billion in foreign-exchange reserves or cutting their planned spending which could result in a recession.

Venezuela is in an even more precarious position, with serious concerns that the country could default due to the low oil prices running down their profits from the oil exports which comprise a major portion of the Venezuelan economy.