Down the Slide

• Author: John Baffes, M. Ayhan Kose, Franziska Ohnsorge, and Marc Stocker

Down the Slide Finance & Development, December 2015, Vol. 52, No. 4

John Baffes, M. Ayhan Kose, Franziska Ohnsorge, and Marc Stocker

The collapse in oil prices since 2014 is the most recent of several in the past three decades and may portend a long period of low prices

After four years of relative stability at about $100 a barrel, oil prices began a more than 50 percent slide in June 2014. The dramatic drop in oil prices joins the decline in the price of other commodities in marking what appears to be the end of a boom, or supercycle, that began in the early 2000s. But the oil price decline is not an unprecedented event. Before the current collapse there were three large declines in oil prices (see Chart 1).

Each of those earlier declines coincided with major changes in oil markets and the global economy. The recent collapse in prices has triggered not only intense debate about its causes and consequences, but has also raised questions about how it compares with those previous episodes.

We analyzed the main features of each episode and found that although each of the collapses had its own narrative, the first and the most recent have eerier similarities, which include a rapid expansion in unconventional supplies and a shift in policy by the Organization of the Petroleum Exporting Countries (OPEC) after a period of high prices. These similarities suggest that oil prices will remain relatively low for some time.

Underlying demand and supply conditions for oil determine long-run price trends as do expectations about future developments. But expectations can also play a role in short-run movements in market sentiment. During the current oil price plunge, revisions of supply and demand expectations were noticeable, but neither exceptional nor unusually large—and by themselves unlikely to cause such a massive price disruption.

Behind the recent collapseBut these changes in expectations coincided with four other major developments: a rapid increase in U.S. oil output, a significant shift in the objectives of OPEC, receding geopolitical risks, and significant dollar appreciation. These factors, coupled with longer-term shifts in supply and demand dynamics, formed a perfect storm that sent prices plummeting:

Supply and demand: Global oil markets have been affected by a long-term trend of greater-than-anticipated supply, especially from unconventional sources of oil production in the United States and, to a lesser degree, from Canadian oil sands and the production of biofuels (produced from plants such as corn or sugarcane). An increase in oil prices after 2009 and exceptionally favorable financing conditions made extracting oil from tight rock formations (shale sources) in the United States profitable and led to a significant increase in U.S. oil production (see Chart 2). These unconventional oil projects differ from standard drilling operations in that they have relatively low capital costs and a much shorter life cycle—2.5 to 3 years from the start of development to full extraction compared with decades for conventional drilling. At the same time that oil supplies were predicted to rise, oil demand forecasts were downgraded as global growth repeatedly disappointed since 2011 (see Chart 3). While both supply- and demand-related factors played a role in driving down oil prices, empirical estimates indicate that supply (much more than demand) factors...